While it appears as though the problems in Europe have faded from view, expect them to return in force over the coming weeks.
Almost two weeks ago, Christine Lagarde called the US recovery tepid and warned against the coming fiscal cliff, however, the US economy is caught between a rock and a hard place.
The economic recovery, which looked promising last year, has been grinding to a halt due to political problems in Europe and the US. European leaders have yet to craft a comprehensive solution to the problems facing the continent. For a year now Greece has smoldered, allowing the fire to spread to Spain, Cyprus, and Slovakia. In the US, Congress is gridlocked, destroying any chance at solving America's fiscal problems.
We are beginning to move closer and closer to a liquidity trap, if we have not reached that point already. While Federal Reserve Chairman Ben Bernanke talks about studying the actions taken by the Bank of Japan he has not learned anything from those lessons. Interest rates have been pushed down to historical lows while economic growth falters and the US government's deficit gets subsidized. The continued spending is not translating to economic growth and the government gridlock is doing more to constrain economic growth than help the recovery.
The subsidy provided by the Federal Reserve's Operation Twist program cannot continue forever. By purchasing Treasury debt across the yield curve the Fed pushes interest rates lower, allowing the US government to fund its deficit at lower yields than otherwise would be available from the market.
One can say that the move by the Federal Reserve has headed off a buyer's strike through their various QE programs as seen in Europe where countries like Spain and Greece have been either locked out of the debt markets or forced to pay higher than expected yields. These countries are in their situations because the markets do not believe that their problems can be solved without restructuring sovereign debt.
The Greek saga has dragged on for years without resolution while structural changes to the economy have not been implemented and the Greek government wants Europe to fund their deficits.
Spain is undergoing a difficult transformation following a real estate collapse which wiped out the banking sector as the unemployment rate jumped above 24% and youth unemployment rates have jumped above 52%.
The buyer's strike is not so much the capital markets attempting to force a solution on the countries as much as it is the EU's inability to craft a solution to make the necessary structural changes, write down bad debt to realistic levels, and adapt to the changing landscape. For more than a year now European leaders have met to discuss the current crisis crafting press releases talking about temporary solutions without correcting the underlying problems.
It is no wonder the markets are not believing the press releases because you can only kick the can so far down the road before the dents turn the can into a clump of metal sitting on the sidewalk.
The LTRO program has already created over 1 trillion euros, injecting them back into European banks who used the cash infusion to either pay depositors leaving for other European or Swiss banks and/or purchase sovereign debt. When the LTRO money stopped flowing the bond purchases stopped and since the banks were the only buyers rates immediately started to rise again.
As of July 11th, the estimated federal debt outstanding is approximately $15.876 trillion dollars, less than $500 billion dollars from the statutory debt limit of $16.394 trillion dollars. The US pays an average interest rate of 2.72% on the outstanding debt. For every 1% increase that would account for an additional $158 billion dollars in interest expense added to the federal deficit on top of the estimated $1.327 billion dollar 2012 deficit. This is a rough calculation but if you dig down into the debt numbers you begin to grasp the significance of the problem. Given that the difference between the debt limit and the debt outstanding has fallen to less than $500 billion dollars the clock is ticking away on the debt limit with the ceiling expected to be hit at the end of the year, close to when the mandated budget cuts and tax increases are expected to take effect.
The sad part is Congress has not taken any blame for the poor economy when Congressional gridlock is precisely to blame. The House has voted to repeal or defund Obamacare for the 33rd time last week. If only they put such effort into fixing the other problems facing the country like dealing with the expiration of the Bush tax cuts, automatic spending cuts, the budget deficit, over regulation of business, and the looming debt ceiling debate.
Would falling off the fiscal cliff mean a deep depression? It all depends on what black swans Congress creates to constrain economic growth. The cuts in spending and corresponding falling deficit would help repair the long-term fiscal challenges facing the country. If the landscape after the election clears, money will start to flow back into the economy as businesses deploy capital.
In the meantime investors should be reviewing their positions and preparing for a storm in the US financial markets, reducing their exposure to the S&P 500 (SPY) and NASDAQ (QQQ) while increasing their exposure to gold (GLD, DGP) and silver (SLV, AGQ).
Additional disclosure: I am also long an ETF based on the GLD ETF which trades on the Hong Kong exchange under the symbol (2840 HK).