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“I Am Become Debt, Destroyer Of Worlds”

The stock market bounced back today, but in a fairly unconvincing fashion (if you ask me). After a couple of waterfall-decline sorts of days, a bounce was due and expected, but a reasonably small advance with a fairly small range during the day doesn’t speak volumes about investor confidence.

However, it supports my belief that the slide late last week isn’t (yet) the beginning of a slide into oblivion. Also supporting that point, Greece managed to sell €8 billion bonds quite easily today. I don’t really understand why it was so easy. I suppose there is a deep reservoir of people who don’t want to see a European sovereign go bust – for example, other Europeans – but it isn’t as if that 8 billion will carry Greece forever. They are in dire straits, and as I’ve pointed out here before they can’t print money and that fact is what makes a default possible. I do believe this could be the beginning of the end for the Euro, but I don’t think that end is imminent. Institutions have selfish memes and tend to protect themselves vigorously. In this case, I suspect that other European central banks, big European investors, European corporate entities…they all have a very strong vested interest in holding the Euro together, and they will do so as long as it is possible. And it will be possible for a while.

The Existing Home Sales data today showed a massive retracement of the government-induced spike over the last couple of months, but the 5.45mm-unit pace (well below expectations) was still not too bad. It’s a weak market, but a functioning one. Humorously, Deutsche Bank’s economist argued that the fall might imply that there isn’t much “desirable supply” left out there. Joe Lavorgna is a funny guy…a shortage in the housing market? Economists don’t usually make me giggle, but that made me giggle.

The stock and bond markets didn’t meaningfully react even to the big miss in Existing Home Sales, which points up the importance of always keeping in mind the size of the error bar on the estimate. No one has a clue what the natural run rate of Existing Home Sales is right now, and the data is such a mess that you can’t reject any null hypothesis so…move along!

An interesting factoid that I saw on CNBC today: of companies announcing Q4 earnings so far, 9% have beaten earnings-per-share (EPS) estimates, but 65% have beaten revenue estimates. What does that mean? I think it means that margins have been lower than analysts expected (although there’s a statistical caveat, because the number of misses may or may not correlate to the size of the miss), which means that they’re buying business through lower prices or, on the other hand, are holding prices down while input costs rise. One is a disinflationary spin and one is an inflationary spin. The data suggest the latter, as inflation-other-than-housing has been percolating some, but wage growth (a big input) hasn’t exactly been robust either. I’ll call it a tie on that evidence (with respect to inflation implications), but either way tightening margins are a sign of economic weakness.

But my bigger worry is that some sharper near-term imbalances are brewing. Economic weakness we can work through, if the basic capital markets and economic structures are left in place and government doesn’t take too much of the productive capacity of the country (these assumptions are somewhat in doubt these days, but let’s look past that). What worries me in the reasonably short-term is that there are some big imbalances that are following on the heels of the imbalances that just blew up…and those just about cracked the edifice of Western civilization.

All of these imbalances are of our own making, but none has been created as fast as this one. I will do my best to explain it, and I hope that somewhere my logic falls down and someone can correct me.

When the government runs a deficit, where does it get the money so that its expenditures can exceed its revenues? It borrows, from essentially two places: domestic savers and foreign savers. In recent years, domestic savings have been low, and the government has financed its deficits more and more with money lured from foreign investors who hold dollars. Because the only reason these folks hold dollars is because we are buying more stuff from them than they are buying from us, we have a trade deficit. If domestic savings is stable, then over time the budget deficit and the trade deficit must equal; but a better way to think of this is that budget deficit = (trade deficit plus domestic savings).

This is why folks talk about the “twin deficits,” trade and budget. Large deficits can only be financed entirely from within if there is substantial domestic savings, but we have been discouraging savings for a couple of decades now. The graphic relationship is sloppy, partly because we’re not great at measuring these values and partly because domestic savings ebbs and flows, but you can see that the larger trade deficit in recent decades seems to be at least of similar magnitude as the budget deficit (Source: Economagic.com):

This was a much better chart until 2009.

Well zowie…those last few points are interesting, are they not? The government is running an epic deficit, as we all know, but the trade deficit has been improving. How is that possible? It is possible because domestic savings has been growing by trillions of dollars over the last year.

Now, you might say “that’s great news!” except that it isn’t great news at all. The largest part of that “savings” is the money that the Fed has printed by buying Treasuries, agencies, and other collateral. This is where the rise in the money base (see chart below) is showing up.

All that money IS going somewhere. It's buying Treasuries.

A 1.4 trillion-dollar jump in the money base? Where did I just see a number like that?

That’s right: the improvement in the trade deficit, despite the huge budget deficit, comes almost entirely because the Fed has provided the needed savings with its checkbook. But now here’s the problem. The Fed declares that they are not going to keep doing that, which means that (a) they’re lying, or (b) there is going to be a massive improvement in the deficit of $1.4 trillion or so, soon, or (c) the trade deficit is going to start looking really, really, really bad, pretty soon.

Any guesses for (a), (b), or (c)?

Assuming that the Fed isn’t lying, and assuming that the federal government isn’t going to find fiscal Jesus and slash a couple trillion from the deficit (as I’ve noted though, if they just don’t have any emergencies this year the deficit ought to improve a few hundred billion), then the trade deficit is going to start to look ugly. Epic ugly. Medusa-ugly.

And this leads to the worry – if the trade deficit explodes, then two other things are going to happen, although how much of each I can’t even guess: (I) protectionist sentiment is going to become very shrill, and fall on the ears of a President who is looking to burnish his populist creds, and (II) the dollar is going to be beaten like a red-headed stepchild (being a red-headed stepchild, I use that simile grudgingly).

Others – Warren Buffet is one – have publicly toted up the numbers and observed that it’s hard to figure out how we finance such deficits unless most of it comes from overseas. To entice such largesse, the currency unit will need to be cheaper, and rates will have to be higher.

This is my worry – not a global meltdown, but a U.S.-specific meltdown. Higher rates, higher inflation, lower equities, and a lot of volatility. And it may happen quickly, when it happens.

When might this happen? Putting dates on nightmare scenarios is ordinarily a useless chore. It is usually far better to merely be alert to possibilities and to move quickly when the rock looks like it’s toppling. But in this case, there is a particular time period I am especially concerned about: the end of March (as in, about two months from now).

The Fed is gradually reducing its purchases of MBS, with the intention of ending those purchases…in March. Also, Japanese year-end is in March, and lest we forget the Japanese represent some 20% of the foreign ownership of Treasuries. There is a reason that seasonals for the bond market are weak in the spring. If we can skate past April 1 without something serious happening, then I will breathe a sigh of relief and go back to balanced-rock-watching. But in the meantime, I sleep fitfully.

Categories: Good One
  1. Dan Walz
    January 26, 2010 at 10:01 pm

    Mike (or should I say Shiva), I am requiring all of my financial institutions and markets students to read this for tomorrow. Oppenheimer was an interesting guy.

    • January 26, 2010 at 10:23 pm

      Dan – Thanks! Although students don’t tend to like stuff they’re required to read nearly as much as other stuff, Trinity students are a different breed of cat. I hope they find it illuminating. And I hope you’ll pass along any insightful comments! -Mike

  2. Len Jenkins
    January 28, 2010 at 1:17 pm

    It’s (a) They’re lying, (b) isn’t happening with this bunch, and (c) is not possible.
    It doesn’t change your conclusions but I think you may have a minor cart before horse problem in your thinking on (c).
    For the trade deficit to explode there would have to be a massive increase in trade, the Chinese don’t print the dollars to buy our debt, they print yuan and buy the bucks from local companies who have exported to get them. With near 20% real unemployment here, such an increase is highly unlikely, just look at the trade numbers (or your own chart, the red line’s rise toward 0; less outflow of bucks equal less available to recycle into T-debt). IF THE FED DOESN’T SOMEHOW FUND THE FISCAL DEFICIT, IT WON’T BE FUNDED.
    So here’s the game: Bernanke swears before Congress he won’t monetize T-debt. Check- the H.4.1 shows that Fed holding of same are back to about what they were before the whole crisis began, so technically and directly he’s not; however, if you total up all the other junk in that far left column of that same document that he has bought, you get pretty close to the increase in base your second chart shows. So, the Fed buys the bank’s worthless paper, making the banks flush with cash and holds interest rates so low that it is attractive for the banks to use that cash to buy allegedly risk free T-debt, which of course does NOT remove it from the monetary base. Presto, fiscal deficit monetized without the Fed’s fingerprints all over it.
    As to savings making up any of the deficit, fat chance, the increase is largely mythical. I read some place debt retirement gets counted as savings, and what kind of distorted definition of savings includes, as you state, money from thin air by the Fed? The whole exercise is a shell game doomed ultimately to failure.
    Finally, think what interest rates high enough to attract that $1.4 Tr./anum deficit without Fed finance would do to our crippled economy, and further think what an implosion of the Chinese bubble economy which caused them to become net sellers of T-debt would do to our interest rates without Fed intervention. Plenty of reasons around for sleepless nights.
    So you tell me, (a), (b), or (c)?

    • January 28, 2010 at 1:27 pm

      Wow, great response Len. Thanks! In support of your point, I have a chart in a comment back in December that shows Treasury debt held by banks vs bank lending. Here’s the link.

  1. January 29, 2010 at 5:13 am
  2. March 24, 2010 at 2:17 pm
  3. March 24, 2010 at 8:02 pm
  4. December 16, 2013 at 3:05 pm

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