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Thoughts On Gov't Debt And The Expected Bear In Bonds

Daily State of the Markets
Tuesday, April 23, 2013

Good Morning. Former Vice President Dick Cheney, who may be more famous for his hunting acumen (or lack thereof) than his economic policies, once told us that "deficits don't matter." The likely thinking was that running up deficits during times of need is okay because the good ol' USofA has always been able to "grow its way" out of difficulty. So, the Keynesian strategy employed by past administrations (both Democratic and Republican alike) has been to run up a deficit and assume that economic growth would take care of the problem down the road.

This approach is akin to a family where the primary breadwinner works on commission. Since the business of sales tends to be cyclical, the family may need to borrow on their credit cards or via a home equity loan in order to pay for their expenses when times are slow. And then the plan, of course, is to repay that debt when times are good again.

As you are likely aware, it's the latter part of this plan that Washington seems to have trouble with. Our lawmakers have no problem running up bills on the country credit card. However, paying down the debt (or even agreeing to talk about paying down the debt) is another story entirely. But since nations have been carrying huge debt loads for eons now, it's become a generally accepted concept. In other words, spend now and pay later (via the issuance of government debt) has been fine - as long as the country's total debt didn't exceed some percentage of its GDP.

The budget hawks contend that the debt being run up in Washington has now become a problem of monstrous proportions. Of course, those responsible for running up the debt counter with the idea that deficits are misunderstood and that the country will be able to grow its way out of the problem in the future.

Those in favor of running huge deficits also argue that since the amount of interest being paid on the outstanding debt is manageable, there isn't a problem - because, hey it's "affordable." Another argument being made is that the debt/deficit situation is actually improving. Statistics show that the U.S. government's income is actually rising (federal receipts rose 10% over the past 12 months) while spending is slowing (federal outlays fell -2.8% over the past year). And this was happening BEFORE the sequester cuts went into effect.

So, despite the fact that the Gross Federal Government Debt stood at an all-time high of $16.4 trillion at the end of 2012, we needn't worry, right? And according to data provided by the Federal Reserve, the Gross Interest Payments on Federal Debt has fallen to 8.8% of government spending, which is down from 20% in 1990, about 17% in 2000, and approximately 12% in 2007. Therefore, we must be on the right track, right?

While these may be good arguments for the idea of more government spending to try and stimulate the economy, the real story is that interest rates are at generational lows. Correspondingly, the average interest rate paid on government debt has also declined. Currently the interest paid as a percentage of government debt is about 2%. This is down dramatically from the 10% level seen in 1980 and less than half the average rate of 4.51% seen over the past 65 years.

The question here is what happens if the Fed succeeds and the economy improves? Logic dictates that interest rates would then rise. And if Bernanke gets his wish, the economy might finally get on a sustainable growth path at some point soon. But wouldn't this also mean that interest rates would move up toward more "normal" levels?

The point here is that if rates were to return to a more "normal" low level - as opposed to the artificially low levels caused by the Fed's ZIRP (zero interest rate policy), the government's payments on the outstanding debt would more than double. And even that number is probably very low due to the fact that the government is currently adding about $1 trillion a year in new debt.

Thus, at some point, the debt bomb currently being assembled in Washington might just go off. Given that the country currently pays about $331 billion in interest a year, if rates rise to 4.5% that amount would grow to something along the lines of $750 billion a year. So, assuming that Washington doesn't reduce spending, this means that the annual deficit would grow by about 40% when rates rise. Yikes.

What does this have to do with the markets, you ask? The simple fact here is that this country can't afford for rates to rise at the present time. In fact, almost no major country can afford for rates to rise right now. As such, it is probably a safe bet that the central bankers of the world are likely going to err on the side of low rates for as long as possible. Because, in short, a rise in rates could easily push most countries back into recession and we'd be soon looking for QE5, 6, or 7.

So, while rates are artificially low and the economy is expected to improve in the second half of the year (fingers crossed!), betting that rates will rise a lot in the coming months and that a vicious bear market in bonds will ensue may not be the lock that so many are calling for. Again, the bottom line is that nobody can afford higher rates. Thus, betting on the central bankers staying with their stimulus programs longer than expected may be the more pragmatic way to play.

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Turning to This Morning...

Overnight markets were mixed as Asia fell on weak Flash PMI data in China. However, across the pond, investors are celebrating an improvement in Spanish bond yields and the idea that the recent data should encourage the ECB to cut rates at their next meeting. As a result, European bourses are up strong. Here at home, we continue to get a steady flow of earnings and there is some data after the bell this morning. But the bottom line is U.S. futures are following Europe higher at the present time and are pointing to a positive open.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: -2.35%
- Hong Kong: -1.08%
- Japan: -0.28%
- France: +2.30%
- Germany: +1.34%
- Italy: +2.39%
- Spain: +1.87%
- London: +1.12%

Crude Oil Futures: -$0.74 to $88.45

Gold: -$0.10 to $1421.10

Dollar: higher against the yen, euro and pound

10-Year Bond Yield: Currently trading at 1.667%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +3.20
- Dow Jones Industrial Average: +56
- NASDAQ Composite: +9.52

Thought For The Day...

The greatest glory in living lies not in never falling, but in rising every time we fall. -Nelson Mandela

Positions in stocks mentioned: none

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