Tragic Comedy

There were two tremors today, but the one that was expected is likely the one which will have bigger long-term effects.

The unexpected tremor was a magnitude 7.1 aftershock in Japan. Initially reported at 7.4 (which is a much bigger difference than it sounds like), the temblor was also located 20 miles underground rather than near the surface. Even so, 7.1 is not a small earthquake, and it knocked out power to the Rokkasho nuclear-fuel reprocessing plant and the Higashidori nuclear power plant, as well as two of the three power lines to the Onagawa nuclear power plant. But this time, the backup systems were not swamped by the much-smaller tsunami that ensued, and more importantly the Fukushima plant sustained no further damage. No doubt the quake put jangled nerves further on edge, but there was no further extension of the disaster.

The “expected” tremor was the ECB rate hike. The central bank raised rates 25bps, as expected. Even as Portugal was preparing its formal request for $100bln or so, the ECB insisted that this was good for the collective (they didn’t use the word “collective,” since that would make it too obvious).

According to the FT, and unsurprisingly,
Germany welcomed the ECB action. Mr Trichet denied paying undue attention to Europe’s largest economy, asking what Ben Bernanke, Fed chairman, would say “if he was asked the question ‘did you do this or that because of California’”.

This is disingenuous, of course, since Germany is fully 20% of EU GDP but furthermore the main source of the central bank’s DNA, whereas California is only 12% of US GDP and not exactly a ‘thought leader’ when it comes to fiscal prudence. But I’ll concede the point. There is actually one piece of evidence supporting his view, and that’s that real-time measures of German inflation seem already to be ebbing, which would make the need for tightening much less (see Chart, source the Billion Prices Project at MIT).

The Billion Prices Project may not be as thorough as Eurostat, but it's faster. This is German CPI.

As far as I know, the BPP isn’t trying to pick up core prices, so the fact that this measure is declining even as Brent Crude futures reached a new high ($122.78; NYMEX Crude finished above $110) and is up 31% over the last three months is suggestive. The persistent strength of the Euro since year-end is helping restrain prices – a following wind that the U.S. doesn’t have. The fact that the ECB is raising rates (to be sure, there is still ample liquidity from other programs and no one will quickly starve for cash) is odd.

I would describe that move as “comical,” but if you want comedy you really can do no better than the U.S. fiscal circus. Incredibly, the U.S. government is 24 hours away from a partial shutdown and furlough of 800,000 “non-essential personnel.” The battle is between the Republicans’ proposal to cut $61bln from the deficit and the Democrats’ $33bln proposal. The Republicans, controlling the House of Representatives, insist on their number; the Democrats say this would destroy the economy, old people, and orphan children with a limp.[1]

Now, I can tell you that the 2012 budget expenditures as proposed by the President are supposed to be $3.7 trillion, and point out that these two numbers are literally rounding error, but the numbers are so big as to be meaningless. So let me try a couple of images.

Let’s suppose that in 2008 your household had an income of $50,000. In 2009, you got a raise to $53,500; in 2010 you got a raise to $62,000; and in 2011 you got a raise to $65,500. Nice job; in three years you’ve gotten a 31% raise. Now the company comes on hard times, and they ask you to take a pay cut to $64,500. So you quit, of course, rather than take the pay cut.

Or, let’s say that ten years ago you weighed in at 190 pounds. Well, you’ve sort of let yourself go and you now weigh 380 pounds. But you can advance to the next round on The Biggest Loser if you can trim six pounds over the next year. “Forget it,” you say. “I love my Haagen-Dazs!”

That’s the scale of what we are talking about here. In the first example, your 31% rise in salary over 3 years matches the 31% rise in federal outlays over the same time period, and the $1,000 pay cut is roughly equivalent to $61bln/$3.8trillion in FY 2011 outlays. In the second example, your doubling in weight echoes the doubling of federal outlays from the 2001 budget ($1.9 trillion) to the 2011 budget and the 6 pounds out of 380 is akin to $61 from $3.8 trillion.

What is amazing to me is how Obama is turning into the anti-Clinton. The President is actually making the Republicans sound like health nuts when they propose the six-pound diet! It isn’t like the Republicans (at least, the main wing of the party) are being particularly fiscally conservative. How can the President make losers look like winners? He’s the anti-Clinton!

Folks, this comedic interlude actually has real-world repercussions. I don’t see any auctions failing any time soon, but the burden of running these deficits compounds because each year you need to raise all the new cash plus roll all of the maturing bonds. In the first year of massive deficits, you’re mostly just funding the deficits plus the “typical” maturities. In the second year, you have to sell bonds to fund the deficit, plus the “typical” maturities, plus all of the stuff you sold the prior year that matures this year. In the third year, you have to sell bonds to fund the deficit, plus the typical maturities, plus all the2-year  stuff you sold in the first big-deficit year plus all of the 1-year stuff you sold last year. Right now, the 2-year note is $36bln in size, or $432bln/year. So you can see how pretty rapidly, you are stuck running massive auctions every day, all up and down the yield curve. Heck, we’re almost there now.

Over the last few months, we have had the assistance of the Fed to hoover up about $400bln of those issues (and before that, the knowledge that the Fed would be pursuing QE2 helped backstop buyers). But if you believe what you hear from the hawks, not only is the Fed going to stop buying soon but they’re going to be looking to start selling their stake as well (I don’t believe this, by the way).

Think I’m kidding about the size of the problem? Look at the chart below (Source: Bloomberg). It shows the distribution of the maturing bonds of the U.S. Treasury. Remaining in this year (that needs to be refinanced) we have maturities of $627bln plus about $1.7trillion in T-Bills. Some of those will be rolled into 2012 and roughly $250bln into 2013 (via the remaining 2-year note auctions this year). But in 2012 we will have a further $1.1 trillion deficit to finance (in the President’s proposal it would be $1.1 trillion in 2012, although remember the budget years aren’t calendar years so this isn’t quite right) plus the $1.3 trillion in maturing Treasury obligations to roll (let’s assume that the Treasury keeps rolling the $1.7 trillion or so in bills). That works out to about $9 billion in new coupon-bearing bonds that the Treasury needs to sell every day, or $45bln/week. And again, that’s on top of the bills. And every year that we somehow manage to pull off this trick, we add a bit more to the out-year stacks – the 3yr, 5yr, 7yr, 10yr, and so on.

The debt distribution of US Treasuries and all subsidiaries (except FNM and FRE)

Oh, and do you think the budget is sensitive to short interest rates? About 40% of the debt is maturing by the end of 2012. Now what do you think the odds are that the Fed will aggressively hike rates to a neutral 4% or 5% any time soon?

And does this problem start to sound anything like what Portugal experienced? Greece? Enron? It isn’t the balance sheet that fells most countries and companies – it’s the cash flow statement.

Is there a way out? Not a pretty one. Cutting hard on the deficit might well stimulate the economy after the initial harsh blow, but if our leaders are arguing over $61bln or $33bln I doubt we will soon see $500bln pass.

The market reality is that today, the dollar is already weakening. After rallying through the first part of 2010 due to the sovereign debt problems in Europe, it began to decline despite the fact that those sovereign debt troubles have continued. A declining dollar tends to increase the price of imports, most obviously energy imports, and helps to push inflation higher (albeit with a long lag). And to the extent that investors expect the currency to continue to underperform – perhaps because we have a dovish central bank while Europe has a hawkish one – it makes them less anxious to buy U.S. dollar-denominated issues (like Treasuries).

Some people think that a declining dollar is good for stocks, because it increases the value of exports and makes our products more competitive on world markets. True, but remember the U.S. is a substantial net importer overall, so the balance is clearly negative. It surely can’t be that all of the bad effects accrue to households and all of the good effects accrue to business. Businesses have energy costs too, and a lower currency also diminishes the opportunity to manufacture more cheaply abroad. Higher inflation and higher interest rates overall are surely not good for stocks.

On that cheerful note, I will close for the day and probably for the week although if something dramatic happens with the government shutdown I may write a comment. Obama, Boehner, and Reid suggested tonight that there was a chance a deal could be struck by mid-morning, but as I’ve pointed out it isn’t something that’s likely to be dramatic. Unless, that is, you find six pounds on a 380 pound man dramatic.

[1] Actually, this isn’t true. Under the No Orphan Children With A Limp Left Very Far Behind Act, both parties agree that limping orphans should be protected by the government.[2]

[2] Just kidding. There isn’t a NOCWALLVFB Act, but everyone agrees that ambulatorily-challenged independent minors should get the government’s full support.

    April 8, 2011 at 1:00 am

    So, now that the dollar is THE PREFERRED carry trade vehicle, sounds like the run from the dollar is to intensify, don’t you think?

    How far is the world from the anticipated dollar collapse, in your view?

    • April 8, 2011 at 2:55 pm

      I don’t know that the dollar will COLLAPSE per se…it’s too connected to everything. It’ll just slide and slide and slide.

  1. April 8, 2011 at 11:16 am

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