U.S. Debt Problem, Financial Repression In Focus: Choppy Waters Ahead

Includes: VXX
by: Colin Lokey

Tuesday wasn't the best day for the U.S. government in terms of negative media attention. As the eurozone debt crisis wears on, the public is becoming more self aware regarding America's own debt problems and the backdoor mechanisms the Fed has employed to remedy them. On Tuesday, the New York Times ran a piece by Catherine Rampell entitled "As Low Rates Depress Savers, Governments Reap Benefits" which outlines for all to see the way in which the government is bailing out borrowers (including itself) by taxing savers in the form of negative real interest rates in order to make what are essentially transfer payments to debtors.

After humanizing the story by recounting the tales of several former depositors who pulled their money from banks after becoming fed up (or 'Fed' up) with ultra low interest rates, Rampell goes on to describe how financial repression works:

"Over time, interest rates below the inflation rate allow governments to erode or liquidate their debt...using a variety of tactics to encourage captive audiences, like pension funds and banks, to buy their bonds. Consumers...are subtly subsidizing governments without even knowing it."

I have outlined this policy on several different occasions and it should be noted that Deutsche Bank estimates financial repression will cost investors $163 billion over the next decade. The government has also ensured that the market cannot set rates on its own by implicitly encouraging the Fed to purchase massive amounts of government debt and ensuring, through tough capital requirements, that banks hold more Treasury bonds than ever before. This works to impair the market's price-setting mechanism by concentrating control of the securities in the hands of a relative few 'insiders':

"...bank holdings and central bank purchases of government bonds facilitate 'inside' ownership of government securities, effectively ensuring that rates bear little resemblance to what a market price would be if a larger share of the securities were owned by 'outsiders'"

The government was also lambasted by German finance minister Wolfgang Schaeuble Tuesday who, in a speech to the German parliament, said the U.S. debt level was much too high and posed a threat to the world's economy. Echoing Schaeuble, Moody's said Tuesday that it will likely follow S&P in cutting the U.S. credit rating should Washington fail to devise a feasible plan for cutting the nation's debt by the end of next year. Moody's also noted that the U.S. needed to maintain some semblance of order in its next debt ceiling negotiations which will likely take place in the fourth quarter.

Increasingly, Americans and the rest of the world are becoming unsettled about the U.S. and its policies regarding debt. Currently, savers are paying the price in the form of negative real interest rates, but they will be both unwilling and unable to turn the situation around by themselves. Another way of saying this is that monetary policy (low rates and Fed Treasury holdings) cannot, in the end, bring the situation under control. Unless you believe that Washington will suddenly begin working like a well oiled machine in terms of fashioning and implementing policies that promote fiscal sustainability, it may be wise to brace for turbulence in the coming months as the debt ceiling and the fiscal cliff take center stage. In my opinion, this turmoil will spill over into stocks as uncertainty is always the enemy of the market and as such, I recommend staying long volatility (NYSEARCA:VXX)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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