How Will Obama's 'Trillion Dollar Deficits' Affect the Markets?

The New York Times has an article this week reporting on US President-elect Barack Obama's warning that there will be 'trillion-dollar deficits for years to come." What does that mean for the markets?

The first line of recourse will be the issuance of Treasury bonds; in other words, the US government will look to borrow money, offering to pay it back with interest. The key question, though, is to what extent buyers of Treasuries will be easily found. As we have discussed previously, the very low yield on bonds coupled with the fact that the economic pains are being felt all around the world suggest one of two possibilities: bond rates will have to go up or the Federal Reserve will have to "monetize the debt" -- meaning it will simply have to print more money.

I have stated and continue to believe that the result of increased deficit spending, due largely to government bailouts, in this environment will be debt monetization (even if there is a rate hike, that will only increase the future debt, and thus will only delay and exacerbate debt monetization). I believe this will prove to be inflationary, that it will devalue the US dollar, and that this is the real way the bailouts will be paid for; not via a direct tax, but rather a tax through inflation. Economist Mike Shedlock, however, offers a counter viewpoint:

The Fed at some point will resort to out and out monetization, and that will have the inflationists screaming at the top of their lungs. However, banks will still be reluctant to lend, and consumers and businesses will be reluctant to borrow. In addition, I expect the velocity of money printed to be close to zero and for the savings rate to rise. In aggregate, these are not hyperinflationary things. Heck, they are not even inflationary things.

Admittedly, I am one of those inflationists who will be screaming at the top of my lungs.

There are two reasons I believe debt monetization will be inflationary:

1. I disagree with the notion that banks won't lend and consumers won't borrow. As I recently noted, we are seeing a declining TED spread as well as an increase in many money supply metrics (M1, M2, MZM). And even in this environment, we have seen companies like Verizon be able to secure a massive $17 billion loan.
2. Even if lending is reduced due to the economic climate, debt monetization increases the likelihood that foreigners will not only stop buying Treasuries, but that they will sell the ones they have, and will dump US dollar holdings out of a concern of dollar devaluation by the part of the Federal Reserve. This suggests there will be a "run on the currency," similar to what was seen in Argentina. See our previous article on the similiarities between the US economic crisis and the Argentinian crisis of 2001 for more on this subject.

How to Trade This Scenario

Timing is the key issue for trading this; we are currently seeing a rally in the market, though I expect that at some point in the second half of 2009 we will see the concerns about the Treasury market begin to manifest. As a trend-following trader I look for momentum that corresponds to my fundamental viewpoint, with the exception of precious metals, which I treat as buy and hold type investments.

With that in mind, here are the conclusions I am making based on the trillion dollar deficit scenario:

1. US dollar will fall in value. For stock market traders, UDN is an ETF to watch.
2. Dollar hedges like gold and silver will rise. GLD and SLV are corresponding ETFs.
3. Both monetization of debt as well as a hike in interest rates will send bond prices falling, as a rate hike devalues all bonds previously issued at a lower rate while monetization of debt introduces inflation concerns and the possiblity of the bond being paid back with a currency that is worth less.
4. A rate hike, which I think is increasingly unlikely given the Fed's behavior though still possible, will be bearish for US stocks. DOG and SH are inverse ETFs worth considering in such a scenario.

Disclosure: Long gold and silver; currently short US dollar against Australian dollar.

Comments

[Michael Fit...:]

It's not "Obama's" trillion dollar deficits. If anyone should be tagged with this label, it's George Bush, who doubled the US fiscal deficit from just under $5 trillion to over $10 trillion in 8 short years. That's doesn't even take into account the "bailouts". On top of that, we have nothing to show for the money but two on-going oil wars in Iraq and Afghanistan - no social security funding, no energy policy and infrastructure, no health care, no nothing. As long as the US government continues to try and solve what is a economic commodity problem (oil) with financial hijinx, the US will continue to slip into the economic abyss. The only chance we have is to adopt a strategic long-term comprehensive energy policy like this one:
thefitzman.blogspot.co...
i agree with your comments on gold.

Jan 08 06:30 AM

[capital pains:]

In case anyone missed it: The US dove into the economic abyss years ago.
Also, in case anyone missed it: George Bush left Texas in the same state of broke when he left the govenor's office. - 8 years ago. Our "zero talent", soon to be ex-prez will go down in the annals of history as our worst president, joining the close second worst prez - the indredibly inept - Jimmy Carter., followed by our old friend; Herbert Hoover (another genius)...
Blame game aside - The world is right along side the US. Nobody has the answers..Not even Cramer or the Fast Money losers !
Thanks to the "best and brightest" at Goldman. Lehman. Morgan, Bear
the world's investors sit with tons of valueless crap on and off their fabricated books.
The crux of the problem is housing. Until all lenders revalue their losing mortgages based on current appraisals, issue new mortgages based on realistic valuations, the economy cannot move out of stagnation.
It's simple - The banks must redo their mortgages so homeowners can stay. This should have been the requisite for the idiotic TARP money thrown at Paulson's pals. Now that the banks have scoffed up $350 billions, the remaining $350 should have oversight and actually serve to rescue the economy not the rich friends of Hank Paulson. Would this not make perfect sense ?

Jan 08 06:55 AM

[RBSTOCKS:]

THANK YOU MICHAEL FITZSIMMONS AND CAPITAL PAINS!!!!!!!!!!

I am from Texas and I can asure you that George Bush has done business as usual from the office in Texas to the White House. It is just more Bushshit. I can only hope that more damage will not be done in the comming weeks before he is ousted. To those of you who think I am on the attack, I can assure you I am not. I think Bush would be a great guy to sit around a campfire drink cold beer and tell lies with. It is a shame to see so many people already placing the blame of all this mess on Obama's sholders saying it is Obama that caused all this for the last 8 years. WOW where do these people come from?

Jan 08 08:25 AM

[y3115y:]

From history internationally, if a government printed too much money, hyperinflation always came and brougnt the government down. In China in 1949, the daily inflation was more then 100%, and Chiang's government was gone in a year. I hope our government knows this.

Jan 08 10:04 AM

[Jason Rines...:]

Agree Mr. Patel. Mr. Fitzsimmons, insightful as usual. I suspect oil to retest it's June spot price in 2010-2011 and trickle down effects. Other sectors in the reinflation attempt seem to be in green energy (nat gas especially), higher education, I.T. and healthcare. Too early to make strong predictions, need to see fiscal stimulus package 1st. Lots of 'insiders' talking about what that plan looks like, but opinions are like *ssholes, evereone has one. I want to see the fine print before buying anything on the back of experimental reinflation attempt.

GWB attempted budget cuts, funding for Higher Ed and pushed hard on alternative energy immediately after 911. The foreign policy blunders and 'trust but DON'T verify' 2004 and beyond will haunt the man for a long, long time I am sure. But his villification had more to do with smart political attacks by the Democratic party and GWB's failure to go in front of the American people to pressure the 110 Congress of 2006-2008.

Jan 08 10:16 AM

[Guero:]

Like it or not, Obama is merely telling us the straight skinny...namely years of deficit spending like drunken sailors and selling our debt to China are coming home to roost, just like pigeons.

Trying to pin this pile of crap on only the 110th Congress is very funny, this cycle was out of control before they hit town, although they didn't help much by cowering before Bush's bluster and giving into his childish demands. But make no mistake, Bush's pet wars & irresponsible fiscal management with the first 6 years of GOP-controlled Congress are the roots of this mess.

Jan 08 11:35 AM

[isaac the t...:]

Just how big will the new US economy be, once excess debt and leverage is wrung out through currency devaluation, higher interest rates, and a massively increased national debt? Much smaller, it seems to me. It will be painful to digest these "adjustments", very.
I belive a crucial question is timing. Can we get some solid footing before devaluation and inflation come roaring in, and before our national fuel bill re-escalates? I'm not too optimistic about this timimg. we're going to be extremely lucky for things to happen so fortuitously.
Secondly, Partisanship is for fools (or smart people acting foolishly).
Thanks for the article.

Jan 08 11:48 AM

[wheresmymoney:]

I think people pick too much on President Bush. Think back to the 9 11 when we got attacked. I think people forget how Bush acted quickly to make up Home Land Security and beef up our airports, etc. We have never been attacked since. We must be able to listen in on phone conversation to catch Al Quidia and other Terrerorists groups operating here in the USA. Spying is part of keeping our nation safe,all nations do it, and if the liberals think terrorists should have the rights of Americans, even if they are not citizens they are ignorant. Where would we be now if Saddamn Hussian was still in power would he have teamed up with Iran? Bush put us in that area to get rid of Saddam and be close to our enemeys, that is one thin they don't like. I think a big mistake Bush has made though is that Iraq is loaded with oil, so much they can't even pump it all. I think the Iraqi goverment not only owes us billions on dollars for the war we did to save their ass, they should supply us with oil for saving their country. If they wont pay us the billions they owe us for the war they should give us oil as payment. We shouldnt have to buy oil from idiots like Chavez, etc. Iraq owes us too much and we should get part of the oli as paymentor at a guaranteed low price. Maybe we should of taken over the goverment and made it part of the United Staes becasue then we would have owned the oil fields. This may sound stupid but do the Iraqi people appreciate what we have done for them? I think not. I know a soldier working in Iraq in the prisoner of war prisons and the US gives the prisoners, decent food, little fans because its so hot, etc. He said the Iraqi's told him as soon as the US is out of Iraq and takes over the prisoner of war camp, they will kill all the prisoners, they dont waste time with courts and money they get rid of the terrorists quickly. I commed Bush for keeping us safe, and giving us tax breaks, I think he was distracted by the war and terrorists from the ecomony mess but this started way back in Clintons years, in fact Clinton let Bin Ladin go when they could have got him easily. Now all of Clintons staff is back running the country, that is no change, that is going backwards and scary!!! Bush isn't to blame for everything that is wrong with this country.Is it his fault the car companys want have the union control them and unskilled workers arent willing to give up ther $73 an hour in pay. I think Bush was wrong with all these stupid bailouts they havent done a thing to help us. Bush did good and not so good things, but it is ridiculous to blame everything wrong with this country on him!!
I am scared to death with Obama as President, as with who he picked for his intelligence pick for his cabinet we are in deep
\sh-t, that person has no experience at all. We will surely see an uprising in terrosism and his spending program will put us in a depression. Obama is great at reading speeches but when it comes to saying his own opinon without a script he is speechless! He hangs around with radicals and the Chicago political machine that is all corrrupt and he and Ron Emanuel is one of Mayor Richard Daly boys. I know because I am from Chicago, ask any one in the state how corrupt the state of Illinois is, and Mayor Daly is mobbed up, he always has been. Now he has two of his boys in Washington, this is scary! This country is in deep trouble, security wise and with Obamas economic plan of Trillions of dollars he will put us in a depression. This whole county is a mess and it isn't all Bushes fault. As Obama makes stupid moves and puts us in danger of terrorists, here at home we are all in trouble!!!! Next he will be talking to Iran who you cant trust anything they say, they need the bomb dropped on their nuclear site now before they have the capibilty which Russia will give them to send a Nuke over our way!!!!

Jan 08 12:50 PM

[wheresmymoney:]

I think people pick too much on President Bush. Think back to the 9 11 when we got attacked. I think people forget how Bush acted quickly to make up Home Land Security and beef up our airports, etc. We have never been attacked since. We must be able to listen in on phone conversation to catch Al Quidia and other Terrerorists groups operating here in the USA. Spying is part of keeping our nation safe,all nations do it, and if the liberals think terrorists should have the rights of Americans, even if they are not citizens they are ignorant. Where would we be now if Saddamn Hussian was still in power would he have teamed up with Iran? Bush put us in that area to get rid of Saddam and be close to our enemeys, that is one thin they don't like. I think a big mistake Bush has made though is that Iraq is loaded with oil, so much they can't even pump it all. I think the Iraqi goverment not only owes us billions on dollars for the war we did to save their ass, they should supply us with oil for saving their country. If they wont pay us the billions they owe us for the war they should give us oil as payment. We shouldnt have to buy oil from idiots like Chavez, etc. Iraq owes us too much and we should get part of the oli as paymentor at a guaranteed low price. Maybe we should of taken over the goverment and made it part of the United Staes becasue then we would have owned the oil fields. This may sound stupid but do the Iraqi people appreciate what we have done for them? I think not. I know a soldier working in Iraq in the prisoner of war prisons and the US gives the prisoners, decent food, little fans because its so hot, etc. He said the Iraqi's told him as soon as the US is out of Iraq and takes over the prisoner of war camp, they will kill all the prisoners, they dont waste time with courts and money they get rid of the terrorists quickly. I commed Bush for keeping us safe, and giving us tax breaks, I think he was distracted by the war and terrorists from the ecomony mess but this started way back in Clintons years, in fact Clinton let Bin Ladin go when they could have got him easily. Now all of Clintons staff is back running the country, that is no change, that is going backwards and scary!!! Bush isn't to blame for everything that is wrong with this country.Is it his fault the car companys want have the union control them and unskilled workers arent willing to give up ther $73 an hour in pay. I think Bush was wrong with all these stupid bailouts they havent done a thing to help us. Bush did good and not so good things, but it is ridiculous to blame everything wrong with this country on him!!
I am scared to death with Obama as President, as with who he picked for his intelligence pick for his cabinet we are in deep
\sh-t, that person has no experience at all. We will surely see an uprising in terrosism and his spending program will put us in a depression. Obama is great at reading speeches but when it comes to saying his own opinon without a script he is speechless! He hangs around with radicals and the Chicago political machine that is all corrrupt and he and Ron Emanuel is one of Mayor Richard Daly boys. I know because I am from Chicago, ask any one in the state how corrupt the state of Illinois is, and Mayor Daly is mobbed up, he always has been. Now he has two of his boys in Washington, this is scary! This country is in deep trouble, security wise and with Obamas economic plan of Trillions of dollars he will put us in a depression. This whole county is a mess and it isn't all Bushes fault. As Obama makes stupid moves and puts us in danger of terrorists, here at home we are all in trouble!!!! Next he will be talking to Iran who you cant trust anything they say, they need the bomb dropped on their nuclear site now before they have the capibilty which Russia will give them to send a Nuke over our way!!!!

Jan 08 12:51 PM

[RBSTOCKS:]

jetway, I don't even have to read your entire post to see that you don't have a clue. Tell me again why we let Osama go and went after Saddam? In short it was a move on oil that will cost our children both with their lives and from their pocket books. Are we safer, I don't think so. To me you sound alot like a fear munger.

Jan 08 01:05 PM

[RBSTOCKS:]

Oh yea jetway, we are already in a depression!!!!!

Jan 08 01:05 PM

[Kunst:]

Dead-on article! This is the future we have been setting ourselves up for, at an accelerating rate, for a very long time.

The last REAL balanced budget was under Eisenhower. Clinton's "surpluses" are only such because of the "unitary budget", which allows the government to spend the Social Security and Medicare surpluses without counting them in the P&L. The national debt went up while we were running those surpluses. Johnson created a fake surplus in 1969 by shoving expenses into the neighboring years. It's been 60 years since the federal government really spent less than it took in in taxes. Quite a trend, and not likely to reverse any time soon.

On the other hand, the Republicans were supposed to be the party of fiscal responsibility. When Reagan became president, the national debt was $1 trillion. Now it is over $10 trillion and rising rapidly. One trillion of that increase comes from the Clinton years. The other $9-10 trillion (from a starting point of $1T) occurred under Reagan and the two Bushes. Go figure.

For decades, the American people have elected and re-elected politicians who told us we could have the government services we want without having to fully pay for them. This is a sad indictment of our democracy.

Jan 08 01:37 PM

[robert.b.fe...:]

Let's not forget the social engineering started by the Carter administration. Does any one remember the great Carter fiasco? I'm sure some of you do double digit inflation (real inflation not the imaginary kind Clinton introduced.) double digit unemployment and double digit inflation. Any body remember that? How about the community Reinvestment Act (CRA) of 1973 that launched the housing bubble. Does any one remember 1995 when President Clinton turbo charged the CRA. Since when did loaning massive amounts of money to people who have virtualy no chance of repaying their loans make sense? Since when did buying real estate you don't need and can't afford make sound individual policy? Never but we kept right on doing it to make it seem that we are compassionate for the less fortunate. I'm not defending President Bush after all the man is an idiot but you Bush bashers make me sick. You hate that guy so much that your arguments become devoid of common or any other kind of sense. What are you going to do in two weeks when he's gone? Who are you going to blame in two years when the economy is still in the tank because government intervention will not allow a true correction? Barny, Frank, Chris, Dodd and all of those idiots that insist we must help the home owners that are under water are creating the same monster that Japan has been dealing with for 19 years. Wake up Bush is not the root of all evil and government should not be in the business of bailing out any one. Those people and businesses that made bad decissions will have to fail if we are ever to recover from this failed attempt at social engineering. The CRA has to be repealed all of it. Sorbanes/oxley has to go as well. Glass/Steagull and the uptic rule should be reinstated immediately and government should get back to it's real buisness: Protecting us, providing conditions to let the economy grow and providing those services within it's perveiw.

Jan 08 02:12 PM

[robert.b.fe...:]

My bad. the third item should have read double digit interest rates on every type of loan including mortgages.

Jan 08 02:14 PM

[AndrewBaker:]

Well, George Bush's pseudonym is Jetway! As he will soon have time on his hands, perhaps he will go back to school to learn grammar and punctuation.

Seriously, the only way out is to inflate so that people don't cry so much over their loss of "wealth" (which was illusionary anyway). I like the thought that mortgage lenders could review the monetary value of the mortgage debt based on real value, but that's just too difficult. No, if your $500,000 is still $500,000 in, say, five year's time, you will not dwell too much on the fact that your $150 shoes then cost $300.

Jan 08 03:32 PM

[henarl:]

Maybe we could all agree that BOTH Republican and Democratic administrations have been inept self serving idiots for at least the last 60 years. Any progress this country and it's citizens have made during that time has been in spite of, not because of, the government.

Jan 08 05:38 PM