In recent months there has been a flight to US government debt, both notes and bonds as people and institutions seek financial safety. This flight has bid up the price of Treasuries beyond levels justified by market facts or experience. Treasuries are in a bubble. Bubbles do not endure. Painful bear markets always follow. As long as the majority of investors think Treasuries are the safest of havens, Treasuries will be in a bubble. When the majority view changes, which will happen with no notice and abruptly, the Treasuries bubble will deflate quite rapidly.
There is no modern precedent for the amount of debt governments---local, state, national and supranational (the IMF is considering its first bond issue)---are planning to issue in the next 12 to 18 months. There is no modern experience with such a dramatic inflation in public debt, globally. The US government alone plans to issue over $2trillion in bonds and notes. Other governments, chiefly EU members, expect to issue another $1trillion in debt.
The projected 3 year cumulative deficit of state governments in the US is over $350billion. In addition, government owned, controlled or financially backed companies, worldwide, must roll over hundreds of billions of dollars in existing debt in the next 24 months. Then there is the prospect of TARP2/Bad Bank, which could be much bigger than TARP1. Finally there are the hundreds of billions of dollars in sovereign debt, issued by increasingly shaky small to medium nations in Latin America and Europe that must be refinanced. The plans to issue so much government debt so quickly are both mad and bad---but chiefly bad (to quote John Buchan).
Investors thus face the prospect of a vast expansion of public debt with either no expansion in collateral or an actual compression in collateral. For example, the collateral for US federal debt consists of tax revenues, which are shrinking and the value of financial and physical assets owned or controlled by the government. These assets are eroding in value. Buying government debt appears similar to buying a bad mortgage. The value of the home is falling and the homeowner's income is declining while household expenses are soaring. We all know what happens to investors who buy such assets.
Consider now what may happen to investor psychology and behavior as the credit environment further deteriorates because of:
- Another tremendous wave of consumer and corporate credit defaults and residential and commercial real estate foreclosures as unemployment rises globally and in the US approaches 10% and exceeds that in the EU. All the TARP1 money will be vaporized by bank write offs. The banks will be in the same capital position they were in pre-TARP1.
- Sovereign debt is downgraded for several European and Latin American nations and a mid sized European or Latin American country defaults on its external debt.
- Russia imposes (disguised) capital controls as the ruble crashes, Russian foreign reserves decline sharply, the Russian stock market barely functions and several Russian companies default on international obligations.
- The UK has two or three failed gilt auctions within a 90 day period. Sadly, the UK is the most vulnerable important economy today. Its two great competitive advantages have been domestic oil and gas production and financial services. The former is declining, which means a worsening trade deficit which the UK cannot afford, and the latter is in a depression. The UK has no obvious third great competitive advantage around which to organize its revival in the near future.
- Half a dozen sizeable and a dozen small municipalities in the US default on bond payments and a large US state replaces cash interest payments on debt with illiquid PIK or IOU gimmicks.
- The $4trillion money market industry is forced to further liquefy its portfolio, badly squeezing the commercial paper market and reducing interest on money market funds to under 1%.
- China is unwilling or unable to increase the share of US Treasuries in its foreign reserves portfolio. It was China's decision to become a net seller of Fannie/Freddie debt from being a very large net buyer that forced the US government to nationalize these two debt addicted entities and, so far, has put $75 billion of taxpayer money at risk. The fact that today every man, woman and child in the US already owes the Chinese government over $3,000 each should focus our mind.
None of these outcomes are predictions: they are conjectures and supposals; an aid to scenario formation. However, if these things occurred, investors would conclude that even the most sedate financial assets do not provide a haven. Then, it follows that:
- Interest rates on US government debt(federal, state and local) must rise appreciably to compensate investors for risk.
- Inflation must return with force(as the economy is force fed dollars).
- The dollar must fall markedly.
The timing of all this is difficult, perhaps impossible, to forecast but the window seems to be between 6 to 18 months from now.
The reaction of investors to unpalatable financial assets is naturally, to turn to real assets for safety.
There are not many real assets that have the scale to absorb the tremendous shift of capital amongst asset classes that must occur. The most notable assets investors will turn to are:
- Energy reserves and high quality exploration prospects: oil, natural gas, coal and uranium. This suggests that the price of globally traded energy will jump as money floods in while production is virtually stagnant .A tripling of raw energy prices in 3 years might result. Good news for despots( not necessarily the current ones) in Russia, Iran and Venezuela, no doubt, but bad news for billions of ordinary people in net energy importing nations.
- Energy projects (efficiency, renewables, carbon control) that taxpayers and utility ratepayers are coerced into subsidizing heavily via financial and purchase guarantees where developers/sponsors can recover their equity within 18 months. Government mandated subprime lending is coming to favored energy projects, with the same ugly consequences as government mandated subprime real estate lending. There will be neither transparency nor accountability in loans made to these projects, many of which will be dishonestly appraised at high value. Congress and the Administration will ensure darkness and deceit. Vendors of engineered technology, software and professional services to these projects will do very well, if they insist on payment before project completion.
- Raw land or large tracts of developed land with no structures on them(the transaction and holding costs of land are much lower than for buildings) as well as farmland and ranchland.
- Precious metals, mostly gold and platinum, and gems.
- Iron and copper ore and bauxite.
- Water rights.
We will witness the paradox of rising food and energy prices (as a monetary phenomenon) in a stagnant economy with high unemployment. Markets will not break; institutions and instruments will. Markets will not fall; governments will. The fires will burn hot and bright. Then, after the destruction, there will be an explosion in private innovation; hundreds of new community banks and investment funds will be formed; scores of thousands of new ventures will be launched; millions of new jobs will be created. Once again, all will be well. But first, we must navigate the shards and rubble from the bursting bubble in government debt.