E-piphany

Thursday

It isn’t yet clear to me whether the rally in stocks today was a rip-snorter or a snoot-ripper, but either way it was successful. The S&P rallied 1%, mainly because of positive spin on Greece’s condition. I do say “spin,” because the EU didn’t announce anything specific other than the standards they will demand from Greece. They promised “determined” action, but exactly what that means seems not to have been determined yet. Sort of an indeterminate determination, if you will. But the equity market, which as we all know loves clever sophistry, figured that news was better than a sharp stick in the eye and recent trends (strong dollar, weak commodities, strong Treasury market, weak stocks) continued to lose steam. The 10y T-Note contract lost 4.5 ticks, which actually isn’t that bad a show considering the 30y bond auction was a bit weak (but better than it could have been!) and Initial Claims was much stronger than expected…although in this latter case, the Department of Labor implicated some seasonal distortions as partly to blame. It’s hard to get anything out of Claims these days to make sense.

The 10y Treasury note itself ended up at 3.72%, 10y TIPS at 1.45%, and 10-year inflation swaps at 2.64%. The shape of the inflation swaps curve implies that the market is discounting 1.3% inflation for calendar year 2010, 2.0% for 2011, 2.4% for 2012, 2.6% for 2013,  2.8% for 2014, and then leveling out at 3.0% or 3.1% thereafter. All in all, a very regular inflation curve, as it has been for some months now, and fairly optimistic about the Fed’s ability to neutralize all of these dramatic swings in liquidity and the fortunes of various governments around the world. I can’t say I’m so sanguine. If you buy 10 year inflation swaps at 2.6%, what’s your downside? Is inflation likely to average 1% for ten years? But just one or two bad years of inflation, even if the Fed ultimately wrestles the genie back into the bottle, means a lot of upside to that mark. (That being said, these were a heck of a lot more interesting below 2% early last year!) Put in terms of stuff most people can actually trade, 1.45% real yield looks to me as though it has a lot less downside than 3.72% nominal rates. But that’s just me.

Capitalism Revisited

I want to quickly address a couple of comments that were made to me yesterday about my built-in-ten-minutes model of the mixing effect of stochastic risky outcomes on the wealth distribution of society. One insightful comment (and a shortcoming I recognized in my model) was that the outcomes ought to be phrased as a percentage of the risk-taker’s wealth, since wealthy people can take bigger punts. I suppose to be even more accurate, the percentage also should be inversely related to your wealth since at low wealth, any risk at all is a big risk, but again: I’m not trying to perfectly model society, merely approximate some general effects for demonstration purposes. But I put in the percentage-of-wealth method, with the additional modification that the “risk” can’t be less than $10,000 (since otherwise someone with $0 would be stuck at $0 permanently). Otherwise, the model is as it was.

So the three charts below are for the same initial endowment as before, but the first one shows the future jumble at 10% risks, the second at 20% risks, and the third if people are taking crazy 30% risks. The red line indicates what it looked like pre-jumble. Clearly, the bigger the risks people are encouraged and allowed to take, the bigger the inter-class mixing.

Std Deviation of risks is 10%

Std Deviation of risks is 20%

Std Deviation of risks is 30%

So, riskier bets means that more people move from rich to poor and poor to rich. Not surprising, I hope. Now here is something which is perhaps not completely intuitive. Let’s look at the wealth of the person at the 0%, 10%, 20%, etc percentile all the way until we have the fattest fat-cat at the 100% percentile.

Having some REALLY fat cats is a natural result of capitalism

So here’s your tradeoff. If you want more inter-decile mixing, and more capitalism, and more risk-taking, and more successes and failures, you will always have one lucky sumbitch who never loses and ends up with a huge stack of chips (again, think Bill Gates). In fact, I will go further. I’ll bet you can evaluate a country’s historical embrace of capitalism by the proportion of super-rich people compared to the median, and the way that changes over time (this is a bald assertion, a speculation, with no supporting facts. Just intuition based on the above).

I should make explicit one thing that is important in my argument from yesterday: yes, an important facet of capitalism is that risk-takers should be free to win or lose, and the issue of too-big-to-fail institutions is an important way in which we have deviated from capitalism. Now, I do not favor having the government break up the banks, since the banks belong to the shareholders and not the government. But the government doesn’t need to break them up if they just give shareholders at the large institutions an incentive (or remove the disincentive!) to break them up themselves. Citigroup isn’t the size it is because it’s efficient but because the government is giving the shareholders a more-or-less free option because it is too big to fail. Remove that protection, and perhaps give some tax disincentive for size, and the institutions will split themselves up.

Note that there is a really big difference to society, though, between a Wall Street where there are giant banks that aren’t allowed to trade and a Wall Street where all the firms are small, many are partnerships (as it used to be when Goldman, Sachs were two people and Lehman Brothers were the brothers Lehman), but they are allowed to trade their own proprietary capital (and to blow themselves up, possibly). The latter situation will result in more market liquidity and, by the way, there are lots of other ways for banks to blow up besides risking proprietary trading capital (see: Continental Illinois).

One final note I should make. I think that honest capitalists embrace the fact that they may lose. Speaking personally, I am presently involved in a venture on which I am willing to stake everything meaningful that I have accumulated (if I had no family to worry about, I would push all of the chips in). I do that because I don’t think that I will lose, but I certainly acknowledge that I can. And I do that because I think that if it works, I might some day be a fat cat. So I am not writing about something that is entirely sterile to me. That might color my argument, but now that it is disclosed you can be the judge of that.

Friday

One of the sad repercussions of the financial crisis was the decision by SIFMA (Securities Industry and Financial Markets Association) to eliminate most early market closes from the calendar. Until 2009, most three-day weekends were preceded by an early close in the bond market; most of those are gone, including the one before President’s Day. So, we’ll be working a full day (wink, wink) on Friday.

Assuming that the people in Washington, DC finally have learned how to shovel snow, the government will re-open and release the Retail Sales report for January (Consensus: +0.5%, +0.6% ex-auto) at 8:30 ET. Last month’s report showed a decline, and there haven’t been two consecutive declines since last spring, so the consensus seems reasonable to me. At 9:55 ET the Michigan Consumer Confidence figures (Consensus: 75.0 from 74.4) is worth paying attention to, more than it usually is, since indicators like Claims are kinda messed up right now. If the employment situation is improving, then the Michigan numbers should improve. A decline isn’t quite as significant since other things (such as movements in the equity markets) could explain a fall in the index.

Stocks have managed to bounce enough that some oscillators will be turning and perhaps give a bit of a technical boost to the bounce. Supply is out of the way for the bond market, but both stocks and bonds face the question of what to do about a three-day break with Greece still on a one-headline-per-day diet. How we trade into the final hour tomorrow may tell us something about whether risk appetite is already coming back.

Wednesday

New York, and most of the rest of the eastern seaboard, felt the brunt of the storm today, leading to somewhat lethargic trading and drying up the news wires somewhat. The S&P closed -0.2%, although the 10y note contract dropped 10.5 ticks. Treasuries were weak mainly because lower prices were necessary to move $25bln in 10y note issuance to a thinner market; fortunately for the Treasury, the snow didn’t really arrive in New York until mid-day and the auction was no problem (although the results were a little soft compared to the norm). Bonds tomorrow! $16bln of big-duration stuff, but at least the sturm (if not the drang) should be behind us by then.

Bernanke didn’t speak today, but his testimony was released anyway and it contained unveiled hints that the Fed might someday seek to tighten monetary policy. Clearly, before the FOMC even considers tightening policy (right before a 10% tax hike next year when the Bush cuts expire) they must prepare the market for the eventuality. That will take time, and so it isn’t surprising to see him starting to hint about raising the discount rate, for example, which has only symbolic significance most of the time (moreover, since technically the regional Fed Presidents request an increase or decrease in that rate, it is a good place for Bernanke to yield – no pun intended – some rhetorical ground to the hawkish Members from the regional banks without actually doing anything important to restrict monetary liquidity. Indeed, the Chairman went out of his way to state that these changes “should not be interpreted as signaling any change in the outlook for monetary policy.”

I also saw that Bernanke said the Fed doesn’t expect losses on Bear and AIG: “The Board continues to anticipate that the Federal Reserve will ultimately incur no loss on these loans as well.” Unless my memory is faulty, I believe they have already experienced losses on Maiden Lane. The use of the word “ultimately” seems to suggest that he recognizes that there is a (pretty sizable) mark-to-market loss, but he thinks the securities in question will ultimately pay off. Those of us who are traders recognize this non-trader mindset. The current price is the best estimate of the value. While there may be occasional differences in the net present value of expected future cash flows (value) compared to the market price, especially for large positions where liquidity discounts are applicable, it is very dangerous to hold a position that one feels is “worth more” than Mr. Market is paying for it, because you think it will come back. The Chairman, of course, is an economist and not a trader, which is one reason why the Federal Reserve was never supposed to take trading positions.

Why Capitalism Should Be Preserved

Not that capitalism needs me to defend it, but I find the populist message, that the fat cats at the top are ripping off the little guy, to be as tiresome as I think most of us do by now…even those of us who are little guys! We recognize it (while having some element of truth, to be sure, as most slanders do) as an argument designed to preserve a certain power structure that doesn’t involve fat cats or little guys, but fat little guys (the ones on Capitol Hill). But it is dangerous to attack the heart of the capitalist system, which is the concept that people who take risks may be rewarded.

I think most people focus on the “reward” part of this equation, but the reward – and the redistribution of wealth it implies – is there merely to induce people to take risks. And most folks have only a visceral concept of why some level risk is good for the system.

Not only that, a system that cultivates risk-taking is better for the little guy than it is for the big guy. You may think of an option analogy if you like: if you have a deep-in-the-money call option, you don’t want volatility because it may push you out-of-the-money; if you have a deep-out-of-the-money option, then volatility is good because it may push you into-the-money.

Let me illustrate this with a little simulation. I created a 1000-person population consisting of people whose initial endowment (wealth) is a normal distribution around $75,000, with a $100,000 standard deviation. That is, if you’re in this population and you are 3-standard-deviations wealthy, you start with 3 * 100,000 + 75,000 = $375,000. The minimum wealth is $0, since folks can always declare bankruptcy and have nothing. (n.b.: probably the distribution should be lognormal rather than truncated normal, but give me some slack for the purposes of illustration).

You can imagine everyone standing in a line, from poorest to richest. The poorest is someone with $0, at the 0th percentile; the richest is somewhere up there around $450,000 at the 100th percentile. But here is where it gets interesting.

I now subject each “person” to 30 random shocks of random size (standard deviation $20,000). Think of it as everyone having one “lucky” event per year – some of them lead to more money, some of them lead to less money; of course, we still have a $0 floor (and that’s important! Bankruptcy, as opposed to indentured servitude, is an absolute must in a capitalist society, which is one reason that the indentured servitude that bank employees are being forced to endure, for the sins of prior bank employees, is such a bad idea).

Before you look at the result below, consider whether you like this system if you are a fat cat, or if you are a little guy. If you are a fat cat, bad luck stands a far greater chance of hurting your position in society than good luck stands to hurt it. And if you’re a little guy…well, as Dylan said, ‘when you got nothin’, you got nothin’ to lose.’ So the result over time is that there is a lot of mixing of little guys and fat cats…fat cats who become little guys, and little guys who become fat cats. Now look at the chart, which shows each of those people standing in line where he started, but the height of the bar indicates what percentile he finished in. That is, the guy on the far left was at 0%, but many of these folks moved into 30%, 50%, even 80% percentiles! Most of the fat cats are okay, but even the ones on top slipped some.

Initially Ordered Sequentially, History Has A Way Of Scrambling

Another way, perhaps a better way, to look at the mixing is shown below: the guys in green are the fat cats who started in the top quintile (80% and above), the guys in the reddish color are the little guys from the bottom quintile (20% and below). Look at how spread out both groups have become.

Over Time, "The Wealthy" Changes

And note, by the way, that I am ignoring that many of the little guys are little because they are young, and likely to be moving up (and having more chances for luck over longer remaining lives) anyway. This is just the result of random mixing.

Now here’s the key point: I have done nothing to transfer the wealth from fat cats to little guys. The process was completely random, and the overall wealth of the population is roughly the same (slightly higher since I assumed anyone with sub-zero wealth defaulted back to 0, and there is no offsetting drain for that gain). That sort of mix happens, and it is powerful over time.

If I want a more egalitarian society, I want one in which that guy on the left has a chance to get to be the guy on the right, not one in which the guy on the left and the right meet in the middle. The reason I want this is because it is the little guy trying to be a fat cat who becomes Bill Gates. Okay, bad example because Windows sucks, but you get the point. Even a sucky Windows is better than paper and pencil.

So why not take this natural mixing and “augment” it with some involuntary wealth redistribution? The key input that determines the degree of mixing is the standard-deviation assumption I used above. That is, the riskier are individual decisions, the more society will mix. Will a too-risky society mean that no one takes risks? Not at all. The people at the bottom have nothing to lose. At some point, the people at the top might not take risks, but the people at the bottom should like that shot at the brass ring (which is why they are overrepresented among lottery ticket buyers). At some point, I suppose a society that is too risky becomes a society in chaos…but south of that point, more risk is good.

But if government redistributes wealth too much, the motivation to take risks is lessened, since the people at the top are having their “cushion of safety” taken away while the people at the bottom don’t need to take any risks to improve. Simply put: the more redistribution you have, the lower the standard-deviation (the smaller the risks people take). The combination may or may not result in more inter-quantile mixing, but it sure as heck means that the wealth of the population as a whole – the pie that ends up getting shared – is smaller.

Thursday

On Thursday, the only economic data of note is Initial Claims at 8:30 ET (Consensus: 467k from 480k). Claims has certainly been more interesting of late as it has turned higher; the original explanation, that California needed to catch up with filings after being short-staffed during the holidays, turned out not to explain the next week’s rise (the state-by-state explanations are released with a one-week lag), and probably not last week’s either. While the Employment numbers were encouraging, that is only because of where we have been before. Without further improvement in Initial Claims, the Unemployment Rate will stay stubbornly high.

Yesterday I said that Dow 10,000 was “in the rear-view mirror.” If that is the case, then I am driving backwards. Actually, two qualifiers save a little bit of face. I said “perhaps,” and “for now,” which strictly speaking was correct.

I’m kidding. That was a bad call and illustrates why I avoid predicting one-day moves.

Stocks, of course, rocketed higher today. Supposedly, this was due to the possibility of a Greece bailout, but even after German authorities tried to turn the volume down a bit on that rumor stocks remained aloft. That could be due to the fact that Warren Buffett spent some time interviewing a Goldman banker (oh, sorry, it was a former Goldman banker, former Secretary Paulson) on CNBC, a sign in my mind that Warren might be getting a bit nervous about things.

Now, ordinarily no one watches the Wholesale Trade numbers, but today’s sharp drop in inventories, combined with a rise in sales, will be viewed by (a) bond market bulls as a sign that Q4 wasn’t as strong as we thought, since estimated inventory growth added a lot to Q4 GDP, and (b) bond market bears as a sign that inventories will be built going forward since the Inventory/Sales ratio fell. Oh, now I remember why no one watches Wholesale Trade.

I tend to view today’s equity rally with skepticism (the same way, some would say, that I view most equity rallies).

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With the second Great Nor’easter of the week bearing down on us (the first one dropped a whopping two inches on our home), I went out today to pre-dig my driveway. You know, I thought I’d get a few inches ahead of the game before the snow hits. Then I realized something.

Some things, you just can’t prepare for. You just have to wait and dig later.

I fear that what is going to be happening over the next year or two, or possibly longer if the authorities manage to inflate the bubble one more time – the window on that, however, may be closing – is something that we fundamentally cannot prepare for. I don’t mean the financial market moves. For that, we can prepare: we can own a high-quality, global inflation-linked bond portfolio for example, or roll TBill deposits (which has a negative expected real return, but not bad). We can put some amount in commodity indices, and a small amount in high-dividend-paying, high-cash-flow, low-debt-burden stocks (both of them!).

But we cannot prepare for the societal changes that are implied by the mountainous deficit and debt, to say nothing of the Social Security and Medicare entitlements; we cannot prepare for the probability (in my view) that vehicles which are currently tax-free or tax-deferred, such as Roth or Contributory IRAs, will eventually be stripped of their tax advantage (at least for those who have stashed much wealth there); we cannot prepare for the crushing taxes or, equivalently, the accelerating inflation that is the only way to work our way out of these debts. If the government decides, one day, to simply seize your wealth, there is nothing you can do about it. The courts? “[Chief Justice] John Marshall has made his decision; now let him enforce it!” is still the way it works.

But of course, we can prepare for these sorts of things, but moving to the deep woods of West Virginia with a carload of firearms and canned goods and burying ingots of gold in my backyard has a lot of downside. And before you laugh and say this cannot happen, I will tell you it already has: if the government is dictating what wages are to be paid for what work on Wall Street, it is stealing the biggest asset most of the young workaholics there have – the present value of their future labor.

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And meanwhile our President is losing his mind. On CNBC today he was declaring “We cannot have another year of partisan wrangling.” Oh really? “Partisan wrangling” is the only thing that saved this nation from much worse than you were actually enabled to deliver. Let’s hear it for partisan wrangling! But that isn’t where he lost his mind. It was the statement “We cannot have a balanced budget without healthcare reform” which caused me to recollect Ed Asner on Saturday Night Live admonishing his employees “you can’t put too much water in a nuclear reactor.” Did President Obama mean that the healthcare reform, which even his own party says will cost many many billions, will balance the budget? Or was he threatening, saying that he won’t accept any budget that balances unless he gets his prize? Either way, it makes no sense whatever. And honestly, he should let it go.

With all this, people still want to buy equities, and so we get a bounce like we did today. My co-worker reminded me today that “even if they are stupid elephants, a herd of elephants is still a herd of elephants” and there is no point standing in the way of the next stampede, regardless of value. True enough. The real question now is whether these are elephants, or rhinos who tend to forget in mid-charge what they were charging for?

Wednesday may be interesting, if this blizzard really delivers the punch to New York that the last blizzard failed to. Bernanke has already postponed his speech tomorrow, which is less a sign that he can’t get to the venue and more a sign that he doesn’t want to be talking when the market is thin. And it will be thin. This could end up being a problem as the Treasury needs to auction $25bln 10y notes, followed on Thursday by $16bln 30y bonds. The good news is that the runners no longer need to hand-deliver the auction bids to the New York Fed; the bad news is that the Treasury still needs those bids to show up somehow! The person in the 10y trader’s seat must be asking him/herself: “The Man just slapped an extra tax on my bonus and says I ought to get it all in deferred (a.k.a. likely to be worthless) stock anyway since he says I am a bad person. New Jersey Transit is going to be even more of a mess than usual. If I make it into the office, I’m going to be one of 17 primary dealers bidding on $25bln 10y notes, and half of my salesforce won’t be there to distribute the paper. I’m likely to get run over and own more notes than I could possibly want, and take a huge hickey on my P/L.

“Golly, I wonder if I ‘ll be able to get out of my driveway?!”

The call apparently went out today for people to talk up how easy it will be for the US government to finance its huge 2011 deficit while rolling over maturing debt as well. The Wall Street Journal had a comment from an analyst at RBS who declared that “the days of steadily rising Treasury supply are likely behind us,” despite the fact that even a rudimentary calculation (which I ran through on Monday) argues vehemently otherwise. And later, Bloomberg joined the act in an article on the quarterly refunding announcement:

The U.S. plans to sell $81 billion in its quarterly sales of long-term debt next week, saying there’s no need for more increases in auction sizes to finance the country’s budget deficit. (Bloomberg, “U.S. Treasury to Sell $81 Billion in Long-Term Debt Next Week”, 2/3/2010)

The problem is that the Treasury did not in fact say that there was no need for more increases in auction sizes. What they said was (from the same article from Bloomberg!):

Treasury now believes that the current auction calendar provides debt managers with sufficient flexibility to address a range of expected borrowing needs,” said Matthew Rutherford, the Treasury’s deputy assistant secretary for federal finance, according to minutes of an advisory committee meeting yesterday. (Bloomberg, “U.S. Treasury to Sell $81 Billion in Long-Term Debt Next Week”, 2/3/2010)

Notice that nothing was said about the size of the issues on the calendar, just that the calendar itself – indicating which tenors will be auctioned, and when – is currently adequate. That’s not terribly surprising, at least on the nominal debt side. Treasury now auctions 1m, 3m, 6m, 12m, 2y, 3y, 5y, 7y, 10y, and 30y debt regularly. There aren’t a whole lot of points that even could be added! I suppose we could bring back the 4y note (lost in the early ’90s) or the 20y (last seen were the Feb ’06s, auctioned in 1986, I believe), and there is probably demand for some ultra-long notes. Existing issues could be auctioned more-frequently although currently 2y, 5y, 7y, and 10y notes are already auctioned monthly.

But there isn’t a lot of surprise, anyway, that the nominal calendar remains unchanged for now.

And even then, the Treasury is preparing to change the TIPS calendar. In a few weeks it will auction a new 30y TIPS bond, and they are considering adding two more 10y TIPS auctions (to make 6 per year: 2 new issues and 2 re-openings for each) as well as increasing auction sizes generally. This is welcome (and I still think they ought to bring an inflation-linked perpetuity to market). I had mentioned in a commentary in December that the failure of TIPS issuance to keep up with nominal issuance was a potentially disturbing sign. Increasing TIPS issuance will help the Treasury keep inflation expectations (and therefore, the yields at which they will sell the debt) lower than they would otherwise be.

While I don’t think there are very many paths left that do not lead to eventual monetization of the debt, and I suspect that policymakers are beginning to fear that as well, the amount of TIPS issued is still a pittance against the nominal float and won’t keep anyone from turning on the printing press if that is what they want to do. Besides, they need the money.

Tomorrow’s data includes the preliminary estimate of Q4 Nonfarm Productivity (Consensus: +6.5%) and Unit Labor Costs (Consensus: -3.4%). Assuming that the data are anywhere near to expectations, we will see the usual parade of people on CNBC, Bloomberg, and elsewhere proclaiming that inflation isn’t a problem and nothing to worry about since labor costs are declining. Ignore those people. Not only are the ULC data pretty useless in real time, since productivity estimates are revised literally for years, but also the connection between labor costs and inflation is pretty tenuous. There is no doubt that over time, the compensation for labor generally covaries with inflation…but there is very little evidence to suggest that changes in labor costs lead inflation. Indeed, unless you believe that workers have more power than capitalists, the causality makes more sense the other way – seeing inflation, workers harangue for higher wages. Either way, many years of history don’t make persuasive reading for the notion that lower ULC increases should cause fear of price pressures to abate. The chart below (Source: Bloomberg) shows the core CPI price level compared to Unit Labor Costs.

Soft Unit Labor Costs Will Not Lessen My Fear Of Inflation

More interesting, for my money, is Initial Claims (Consensus: 455K). Ordinarily, Claims from the day before Employment is not a market-mover and I don’t really expect this one will be either. But economists are still waiting for the retracement of the recent jump in filings caused, we think, by the clearing of the backlog in California. Every week that goes by without Claims dropping back down will cause projections of the employment trajectory to change. Still, with ADP today showing the best result in two years, any sign of weakness from Claims may be ignored.

“This is a very important point for the markets to understand: The days of steadily rising Treasury supply are likely behind us,” said William O’Donnell, head of U.S. government-bond strategy at RBS Securities in Stamford, Conn.

See what I mean about math skills? Please explain to me how the government can borrow $1 trillion every year in addition to its rolling debt and not have that result in more Treasury supply? I will assume that Mr. O’Donnell was just quoted out-of-context. Maybe he put the accent on the word steadily.

It could be that the size of the quarterly refunding is maxed out, but these days the quarterly refunding isn’t even a particularly large part of the total issuance. Treasury supply will continue to rise for the foreseeable future.

Yesterday, I raised the grim specter of the possibility that the US government might at some point be unable to roll its debt. Today, the Treasury auctioned $17bln of 1-month bills at a sporty yield of 0.04%.

[An aside: Treasury Bill yields can in fact be negative, and have in fact been negative from time to time in the last year or two. This is not a violation of theory, in which negative yields make no sense because currency itself always yields zero. In the real world, no one holds their wealth in physical currency, and while hopefully your wealth is protected in the bank by the FDIC if you are an individual, if you are an institution with millions to invest there is no FDIC program. It may make sense in such a case to earn a negative yield on your “cash” even if there is only a very little, but measurable, chance of your alternative investments losing principal. If, over a 1-month horizon, your investment has a 1% chance of losing 20%, your expected credit loss is 20bps and you would gladly take 0% or a slight negative number over even that long shot. Moreover, we know that investors tend to overvalue the probability of extreme events, so even if there is a .01% chance of such a thing happening, investors may well treat it as if it has a 1% chance and there could still be buyers of TBills at the margin who will pay more than par.]

Any failure of the Treasury to roll its debt, when and if  it comes, will probably unfold quickly…but we are not very near it yet and I have no fear of Treasury paper. I have a bigger fear of inflation.

Vehicle sales were weak. Domestic auto sales, despite all the ministrations of the Ministry of Ministrations, have not pushed domestic car sales above the levels that last prevailed in the early 1980s. This is partly due to the fact that the sales over the last decade have been exaggerated by financing deal after financing deal offered by the (now bankrupt) automakers, but of course it’s largely due to the fact that the Unemployment Rate being at 10%. This is another reason to beware of purveyors of “robust recovery” talk. If Unemployment is high, sales of all sorts of things will be low and, unless you can come up with a satisfactory substitute for employment, they will not improve much until Unemployment is actively falling.

Domestic Auto Sales Still Suck

Consumer Confidence also remains in a funk: the ABC Consumer Confidence number this afternoon declined to -49 from -48 despite expectations for a rise to -45.

We had the television on mute so that we wouldn’t have to hear reports of Geithner saying that long-term deficits are a “corrosive threat” (but apparently not so much so that they want to do anything about them; or, perhaps, the Treasury Secretary simply has no influence. Which is more frightening? Well, given the Secretary in question…). The former Treasury Secretary, however, said stuff that couldn’t be missed, or left unremarked-upon.

Paulson said, in an interview on Bloomberg Television pimping his new and categorically inappropriate book On The Brink:

“In this country, none of us like bailouts. I hated the things we had to do. But they were far better than the alternative,” which to Paulson was “unemployment of 20 per cent…millions of additional jobs lost, millions of additional homes lost, trillions more lost in savings.”

Wow, it is a good thing we had Bernanke and Paulson to save us from those things, which I guess according to Paulson were basically guaranteed if the government hadn’t spent trillions and had the Fed monetize part of the resulting debt.

I just have one question: if Paulson and company were so prescient that they knew what would happen if they failed to save the world, then why weren’t they prescient enough to stop the world from getting into that mess in the first place? These are the same guys who professed to be unable to tell when a bubble was forming in real estate (see Chart, source Economagic.com: it wasn’t hard to see).

Seems Like Prescient People Should Have Done Something

We are not to simply take Hank’s word that a Great Depression would surely have resulted from their failure to take control of large parts of the U.S. economy and to flood those entities with borrowed money; moreover, if it is the case that the Great Depression would have resulted, then I have news for you, Hank: your actions have done nothing but delay the pain for a few years.

That isn’t to say that I believe the Fed and Treasury ought to have done nothing. Indeed, some small percentage of the programs created during the crisis actually had real (positive!) effects and one in particular (the commercial paper program) probably was the action that stopped the crisis from spinning out of control in a short period of time. But even if Hank could claim that some of those actions were warranted, it is a classically slippery-slope argument to claim that therefore all of them were warranted. Paulson is too smart not to know that; he hopes that we don’t know that.

When I heard that the Administration was planning to do away with “don’t ask, don’t tell,” I thought they were talking about the way the Fed and Treasury have managed the economy over the past year, and I was all for getting rid of that policy. It turns out that policy is about something different.

It is not surprising to realize that politicians are mathematically challenged. Nor is it particularly surprising, I suppose, to realize that equity investors often are as well (otherwise there is no way to explain equity prices in the late 1990s that implied long-term growth rates on Internet stocks would allow them to represent the full output of the global economy in a short span of years). But I begin to wonder if the numbers we are seeing these days are so big that people are afraid to even do the math.

Of course, I am talking about the 2011 federal budget, which was unveiled today (really, the true question is how they even managed to get the veil on that beast in the first place. Where did they find such a huge veil?). For whatever reason, stocks greeting the news of a forthcoming $1.56 trillion deficit (before emergency spending, of course) with enthusiasm, rising 1.4% on the day.

It may have been that the ISM Manufacturing report suggested somewhat greater strength than economists had been expecting, although it is somewhat concerning that the Prices Paid subindex jumped aggressively to 70.0 from 61.5. Ordinarily, Prices Paid simply tracks energy prices with a lag, but energy prices haven’t done much of note recently. This is a potential concern, if prices for input goods are rising somewhat more than implied by the biggest industrial input, energy. Keynesians keep saying that such a thing is impossible, that there is too much slack in the economy to get inflation, but it seems normal people are disagreeing more frequently these days.  We will come back to this in a moment.

The wonder of the day however was clearly the 2011 budget announcement, although in some sense there isn’t a lot to be surprised about here: we knew we were going to see mammoth numbers, and the deficit figure (to be fair, it represents only about $5 per star in the Milky Way galaxy) did not disappoint. But I am starting to wonder whether people really understand what this number means.

$1.56 trillion is the difference between income and outlays for the federal government. Another way to say the same thing is to observe that the debt will increase about $1.56 trillion next year. The deficits, of course, must be financed.

A back-of-the-envelope calculation suggests there are somewhat fewer than 200 Treasury auctions per year. $1.56 trillion, divided by 200 auctions, is a mere $7.8 billion per auction. But remember, in addition to raising “new money,” the Treasury must refinance the maturing debt as well. Of the $7.5 trillion in marketable debt already outstanding, some 39% will mature over the next 12 months (Source: Bloomberg). That means another $13.8 billion or so per auction. So, if there were as many as 200 auctions per year the average auction size would have to be $22.6bln.

Now, not all of those auctions can be that large. It is hard to move $20bln 30y bonds, for example, and while TIPS could handle more the Treasury seems reluctant to do it.

And the next year, Treasury will have to roll roughly 40% again of (7.5+1.5 trillion), plus $1.27 trillion in new money.

Lest we get too optimistic about these figures, let’s review the assumptions that the Administration had to make to get the deficit down even as far as it has: 2.7% real growth in 2010,  3.8% in ’11, 4.3% in ’12, 4.2% in ’13, 4.0% in ’14, 3.6% in ’15, 3.2% in ’16, 2.8% in ’17, 2.6% in ’18, 2.5% each in ’19 and ’20. The budget assumes an 11-year expansion, and not a slouch expansion either!

The deluge of issuance that hit the market last year, which was considerably less than will land on the market this year, was made possible by a few things, and it’s worth reviewing which of these things can be repeated. The Fed bought a few hundred billion of Treasuries and, by buying lots more agencies and MBS forced some substitution into Treasuries. The Treasury Department added a couple of new maturities (3y, 7y), increased T-Bill sizes, and increased the frequency of some auctions. Corporate treasurers didn’t really compete hard for the investors, as overall corporate issuance was slow for the first half of the year especially (so investors flocked to Treasury debt as the only game in town), and lingering concern over the parlous state of the global economy kept many investors with heavier weights in so-called risk-free debt than would otherwise have been the case. Most of these factors are not at work this year. Maybe this is one reason that T-Note futures closed 9 ticks lower today (I am kidding, but the direction seems right).

This year, the bill auctions will probably move from the $25bln range to the $30-35bln range (per auction, per week). Next year, perhaps that becomes $40-45bln. As those auctions (and others) grow, the federal government will be sucking more and more savings into unproductive federal projects and wealth distribution, and less and less will be available for private investment. This dynamic cannot produce an 11-year expansion. More likely, it raises the cost of private capital and slows long-term growth as a result of diminished investment in productive private projects. This is bad for future revenues, and the budget will collapse on itself at some point. The nation cannot keep spending without bound, and the amount of taxes that would need to be raised cannot be shaken down from hedge funds, banks, and high-income individuals. Those groups are simply too small to raise these kinds of numbers. No, if the budget deficit is to decline, it will have to be on the backs of the lower and middle class.

That will not happen explicitly. No Congress and no Administration will vote to hike taxes by a significant amount on those who pay almost no taxes now, or who are currently net receivers from the government. Perhaps, if there was a calamity, then this may be an option – let’s watch Greece and see. Or perhaps a hyper-conservative government will be elected, which slashes “non-discretionary” spending such as defense, Social Security, and Medicare. There are not many options here once we’ve headed down the trillion-dollar-per-year route.

None of those things will happen in the near-term, and it is the near-term that should worry us. It is instructive to remember that many if not most crises for failing businesses come to a head not because expenses exceed revenues but because negative cash flow ceases to be financeable. A company starves slowly with no earnings, but if it fails to roll its debt it is death by firing squad: short, spectacular, and final. This is what made the 2008 crisis so terrifying: Bear, Stearns was shot. Lehman was shot. Other banks were within days or sometimes mere hours of being shot.

And our government is tying on its own blindfold and handing out firearms by forcing itself to increase the number and size of its auctions to never-scaled heights.

If, somehow, an auction were to fail to attract enough bids, then the Treasury would likely proceed nervously to the next auction, draw down balances, etc, and pretend as if nothing had happened. One auction failure wouldn’t trigger the crisis, but it would be a very scary sign. And it could lead to exactly the loss of confidence that Fannie Mae and Freddie Mac experienced during the crisis and led to several failed auctions. They had the feds to back them up…but who backs up the feds?

The ultimate failure of the country to roll its debt, of course, need not ever actually happen. Default, for a country that controls the currency in which the debt is issued, is never necessary. If the debt is held primarily by domestic investors, then it is neither necessary nor useful. But if the balance is wanting, then either the Fed will print money electronically, or the Treasury will print money physically. The pain of that solution will fall, as any solution of this magnitude must, on the backs of the lower- and middle-class. It would be of course inflationary, output gap or no (if it isn’t, then we should start printing immediately because it is painless!).

And perhaps this means the smartest assets of all today were the inflation-linked bonds. Breakeven inflation rates rose 5-7bps across the board.

These are the thoughts I had today when I started thinking about a trillion.