Bond
Vigilantes and Deficit Hawks are Extinct; Stocks love DEBT!
By Victor
Sperandeo with the Curmudgeon
Introduction
(Curmudgeon):
In the mid-1980s, the term “bond vigilantes” was widely used.
It referred to large bond investors who would sell their holdings in an
effort to enforce fiscal and monetary discipline. That in turn would increase bond yields,
making it more expensive for the U.S. government to borrow (due to increased
debt service cost). At the first sign
of fiscal or monetary backsliding, bond vigilantes would sell in massive
quantities which would lift real yields to heights that would stop the economy
cold. The politicians would ONLY then make the appropriate policy adjustments to
reduce spending and deficits. Such was the vigilantes’ belief.
“Deficit hawks” are U.S. Congress members who emphasize limitation of the
federal budget in order to control the national debt. They advocate reduced government spending in
order to reduce (rather than balloon) U.S. government budget deficits.
Sadly, both of these entities have disappeared.
Bond vigilantes would’ve sold bonds in mass when Bernanke started ZIRP and
QE monetary policy.
Deficit hawks would not have tolerated the budget busting GOP tax bill in
late 2017 that has produced a budget deficit this fiscal year that will
approach or slightly exceed $1 trillion!
They would also have not agreed to the July 21, 2019 “deal” with the
Trump administration on a two-year budget that would raise spending by $320
billion over existing caps. More on the
impact of that later in this article.
“It’s pretty clear that
both houses of Congress and both parties have become big spenders, and Congress
is no longer concerned about the extent of the budget deficits or the debt they
add,” said David M. McIntosh, the president of the Club for Growth, a
conservative group that advocates free enterprise.
The federal debt has ballooned to $22 trillion BEFORE this
deal becomes law. Despite healthy economic growth, the federal deficit for this
fiscal year has reached $747 billion with two months to go — a 23 percent
increase from the year before.
“It appears that
Congress and the president have just given up on their jobs,” said Maya
MacGuineas, the president of the Committee for a Responsible Federal Budget,
which blasted out a statement arguing that the tentative deal “may end up being
the worst budget agreement in our nation’s history.”
NOTE: The remainder of this article is written by Victor, with
slight edits and Notes by the Curmudgeon.
Just the Facts:
In the 1950’s actor Jack Webb starred in a TV series called
“Dragnet.” Webb played Sergeant Joe Friday, a stoic, poker faced detective, who
often used the expression: “Just the Facts,” when he questioned people during
his investigations.
Debt and Deficits
Analyzed:
“Just the Facts” about the U.S. national debt, makes one
wonder if it even matters? Let’s try to
address that question.
This past Thursday, July 25th another budget was
passed by the House of Representatives with an increase in spending of $320
billion over two years and no debt limit.
The Senate is expected to approve the measure next week. That budget “deal” would raise spending by
hundreds of billions of dollars over existing caps and allow the government to
keep borrowing to cover its debts.
This means an estimated total U.S. budget deficit of $2
trillion more by September 2021. Thereby, the U.S. official STATED DEBT will be
an estimated minimum of $25 trillion, which does not include “Off Budget” items
of more than $10 trillion or Unfounded Liabilities in the 100’s of trillions.
A $1 trillion deficit is about 5% of GDP per year. High, but
not horrible in percentage terms, which is the only legitimate way to portray
the deficit number when it’s in trillions of dollars.
Debt and deficits have been talked about as political issues,
since Ronald Reagan was elected President in 1980. Ross Perot ran for President on the
debt/deficits as the most important problem facing the U.S. That was when the U.S. gross debt was $3.6
trillion on 9/30/91 vs $22 trillion now.
In recent years, financial markets never seemed to care, or
react, to increasing debt numbers.
Astonishingly, just the opposite has occurred -the greater the spending
and budget deficit, the more stocks rallied!
How is that possible?
To me, it’s because the U.S. has a printing press based monetary system
(check the Fed’s exponential balance sheet increase from the end of 2008 to
late 2014) and it is on a “paper” foreign exchange standard (based on the full
faith and credit of the U.S. government), rather than the gold standard we were
on till August 11, 1971.
When FDR changed the U.S. Constitution on May 1st, 1933 (and
the Supreme Court looked the other way by not adjudicating any of the pending
lawsuits at the time) that was the end of Article 1 Section 8 clause 6 of the
U.S. Constitution, which read:
The Congress shall have
the power... “To Coin Money, and
regulate the Value thereof, and foreign Coin, and fix the Standard of Weights
and Measures.”
The key concept was “COIN”
not print money! Further, when the U.S. went off the International Gold
Standard (August 11, 1971), the gross federal debt was a mere
$398,129,744,655.54 ($398 billion)
as of on June 1971. However, as of
September 30, 2018 (the 2018 fiscal year end) it was $21,516,058,183,180.23 ($21.5 trillion).
That means in 47.25 years, the compounded increase in the gross U.S. Debt was 8.81% per year,
while Real GDP grew at 2.75% and the CPI at 3.91%.
·
The eye-popping result is
that U.S. debt is growing at 3.2 X’s GDP!
·
Interestingly, the S&P
500 compounded at 10.3% in the same time period that U.S. debt was exploding!
·
The CPI in the last 10 years
ending June 2019 was only 1.73% or 44% of the amount from 1971.
The evidence suggests: stocks
love debt!
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Curmudgeon Note:
The past decade has seen an incredible increase in federal
debt even as benchmark Treasury yields are decisively below levels that prevailed
for much of the Great Recession. One is
compelled to ask if debt levels (or more to the point, deficit levels) have any
power to explain bond yields?
It’s probably not a coincidence that the sensitivity of U.S.
Treasuries to deficit and debt levels has declined as the role of overseas
foreign-exchange-reserve managers has increased in recent decades. China and Japan have been huge net buyers of
U.S. treasuries with their trade surplus dollars. As of May 2019, each of those Asian countries
owned over $1.1 trillion in U.S. Treasuries.
You can view all major
foreign holders of Treasuries here.
………………………………………………………………………………..
The Fed’s Recent
Monetary Policy - Not Good:
M2 Money Supply grew at 6.15% ($8,430.7 trillion to $13,128.0
trillion) from June 2009 till November 7, 2016 (when Trump was elected
President), according to the St. Louis
Fed.
Yet under the Trump administration, M2 has grown at an
extremely low 4.2% or 32% less than in Obama’s Presidency! The reason is that
the Fed’s Balance Sheet declined by -6.58%, compounded annually, from 11/7/16
to 5/6/19 or 2.5 years ($4,512,936 trillion to $3,808,110 trillion).
This guarantees slower growth and inflation (from 11/7/16 to
date) with the typical year and half lag.
The CPI was only 1.65% in the last 12 months YoY.
The Fed claims they want to “normalize” their balance sheet
to be prepared for the next recession, which they will likely cause by their
“quantitative tightening” policy (aka Balance Sheet Runoff, as we
explained in this post).
Looking back to post WWII or from the late 1940’s, there is
no other period over one year much less over two years that I could find which
had a decline close to these numbers.
It is highly likely a
recession will occur without further fiscal stimulus or a big change in
monetary policy. I wonder if Milton
Friedman is kicking in his grave over the Fed’s recent monetary policy.
On July 26th, 2nd quarter GDP was reported at
2.1%, which was better than expected, but well below 3.1% for the first
quarter. Consumer expenditures rose 4.3%
while business investment slumped 5.5%.
The world economy is slowing as everyone knows (check how
many times the IMF and World Bank have lowered their economic growth forecasts
for this year and next). I don’t think
U.S. GDP will be influenced by a 25 bases point Fed interest rate cut on August
1st, as it is a lagging monetary policy tool. But it does drive confidence, so stocks
always react positively to the Fed lowering the Fed Funds rate. The U.S. economy will not have much of a
reaction, in my humble opinion.
The empirical evidence and conclusions are obvious:
·
In the short run the Fed is
King, especially for a stock market that repeatedly celebrates the discounting
of the same news over and over and over again (see Curmudgeon
Rebuttal to Ray Dalio in last week’s post).
·
“Sovereign Debt” does not
matter in the short and intermediate term, because the Fed backs the debt with
an unlimited printing press.
·
Without a Federal Reserve
System, the government could never borrow this debt.
It should also be understood that since 2014, commercial and investment banks have
materially changed their rules. So now instead of the Fed, the banks are
the primarily printing force of the U.S. currency, and the provider of credit
to borrowers.
Every time banks buy
U.S. government debt they create an arbitrage for themselves! The rules have changed to make selling of government debt a
very profitable and risk-free business for the banks.
As a result, the banks
have been the buyers of virtually 100% of the newly issued federal debt this
year.
See my article The Rules of the Bond Game for how
this works. Here’s an excerpt:
The really interesting
part is (banks) skirting around
mark-to-market accounting, though. Since the banking crisis, banks have
been permitted to hold assets in a special account called an HTM account, which
stands for held to maturity.
Government debt held in
this account is not marked to the market. So even if interest rates rise and
the prices of the bonds fall, the bank reports no decline in the value of the
debt, which means no negative effect on quarterly earnings. But it still gets
to collect the interest. Since early 2014, CBs have been routinely shifting
greater and greater portions of their government debt into these HTM accounts,
avoiding accounting for any mark-to-market losses entirely.
It’s a complex formula
to follow through the different Treasury and Fed accounts, but in effect,
government debt is considered risk-free and therefore can be held without
reserve or capital requirement, and without mark-to-market risk. That is
because it falls under the applicable guidelines that meet the description of
the Basel Committee of the Bank for International Settlements.
End Game for Debt?
So what is the end
game for the Monopoly Debt Game?
It’s in the quantity of “interest” payments, which will become the
largest component part of the total budget in 10 years, in my view.
As of January 2019, the CBO projects “interest payments” in
2029 to be $928 billion. That is without
a recession for the next 10 years! And that’s on top of the longest (10+ years)
economic expansion in U.S. history!
Please note that the U.S.
budget deficit will grow to $3 to $4 TRILLION PER YEAR -FOR 2-3 YEARS in the
next recession if you interpolate the consequences from 2008.
As interest rates decline, more debt will be created because
paper money is borrowed and printed. As
interest rates drop, gold becomes more competitive with low/negative interest
paying debt.
The world has 13 trillion Euros of negative yielding debt!
Gold in terms of the EURO is up 15.9% this year vs gold in U.S. dollars which
is +11.3%.
Increasing deficits and debt causes all currencies to decline
(it’s a “race to the bottom” for global currencies). It will eventually create
more inflation and (in theory) higher interest rates.
Conclusions:
Government debt under the current system (and all things
being roughly equal) will always be funded with printed and/or borrowed
currency from the Fed and the banks.
It is the quantity of the Vigorish (Vig) interest [1.] that
will doom the debt. Why? See the
underworld’s method of loaning money and collections for a paradigm.
Note 1. Vig interest is the charge paid on a bet to a bookie or on a loan
to a usurer. It is interest a loan shark charges.
…………………………………………………………………………………………..
If you borrow and repay
the principal and Vig on time you can always borrow more. However, you better have lots of medical
insurance (POW!) if you repay the principal
and want to borrow to repay the interest!
As long as the interest paid is substantially less than U.S.
taxes collected the game can continue. Interest today is about 11% of tax
collections (federal government revenue). If interest paid is 50% of total
taxes collected, we should all be on alert.
All the empirical experience points to the long run (5-10
years) as the debt timeframe to worry about. In the short run, debt and
deficits apparently do not matter but it certainly looks like a ticking time
bomb!
Closing Quote:
It should be in the forefront of all government dictates to
remember this axiom:
“TO the States, or any one of them, or any city of the
States: Resist much, obey little; Once unquestioning obedience, once fully
enslaved; NO Nation, State, City, of this earth, ever afterward resumes
liberty.” Walter Whitman
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Good luck and till next time……
The Curmudgeon
ajwdct@gmail.com
Follow
the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has
been involved in financial markets since 1968 (yes, he cut his teeth on the
1968-1974 bear market), became an SEC Registered Investment Advisor in 1995,
and received the Chartered Financial Analyst designation from AIMR (now CFA
Institute) in 1996. He managed hedged equity and alternative
(non-correlated) investment accounts for clients from 1992-2005.
Victor
Sperandeo is a historian, economist and financial innovator who
has re-invented himself and the companies he's owned (since 1971) to profit in
the ever changing and arcane world of markets, economies and government
policies. Victor started his Wall Street
career in 1966 and began trading for a living in 1968. As President and CEO of
Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and
development platform, which is used to create innovative solutions for
different futures markets, risk parameters and other factors.
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