The Road to Default: Whaa???

Okay so here is what has been happening:
The yield curve has been going through a mad flattening- indicating that investors are "flying to safety" and that a recession may be looming around the corner. Why has it been flattening? Well, a string of bad news. For one, GDP numbers came out today and only indicated a 1.3% expansion. Considering the revisions in these numbers have been downward of late- this is not good news.  GDP has been expanding but at a slowing rate signaling a possible peak around the corner.

Furthermore, Congress still has yet to come to an agreement with Tea Party-ers being the party poopers by acting completely unwilling to budge with Obama and now John Boehner.  The situation does not look pretty. In fact, its unbearable to witness.

Additionally, consumer sentiment readings came out today at 63.7 which is consistent with recessionary levels.

The Contradiction:

SO we have been seeing people purchase treasuries instead of dumping them, like i had previously anticipated. Was i wrong? Clearly i was. What did i not consider? Treasuries are the most liquid and safe security on earth and quite frankly there is no close substitute.  Gold is not a substitute even though there has been quite the flight to it. Why? Its not very liquid and therefore don't depend on it as much for collateral.

Whatever the case may be we are seeing something extraordinary and totally expected:
TOTAL MASS CONFUSION

Please people! Keep Dancin'

Steven J.

The Road to Default: Deep DooDoo

Okay so what is the situation at hand? Well the inevitable default of the United States of course.  The U.S. will default regardless of whether Congress raises the debt ceiling. You may be thinking the following: But how can he say such a thing? Is there anything we can do to stop it? There is no way that can be true!

Let me convince you that we're in deep shit.

First: Look at Italy. Until this past week they were considered a safe haven for bondholders. Then their eurobonds jumped up to 6% because investors got spooked. Nothing happened that would suggest that they are in fiscal demise. There is no real political instability or real danger of default and Italy's banks are relatively well capitalized with mostly retail deposits.
The U.S. on the other hand has had petitions being signed by influential economists and businessmen urging congress to raise the debt ceiling to come to an agreement.  We also have had default and debt recently come to the center stage and center of attention. In financial markets, anything that even gets a little press ends up being way worse than initially anticipated. For examples of this just look at the subprime mortgage market and how early warning signs were easily dismissed.

In Charles Poor Kindleberger's famous book on the history of financial crisis, one of the most tell tale signs of a major breakdown looming is when a central banker or someone important gives an early warning. The example we can draw from is in 1996 when then chairman Alan Greenspan warned of "irrational exuberance" to describe the tech bubble.  In terms of prescience we have seen numerous warnings from Benny Bernanke about our debt buildup.

No matter what happens the U.S. will default. Cautious investors should get the picture if they haven't already that now is the time to cash out and see what happens.  I could be wrong- but the turbulence that will ensue regardless as Congress fights over what to do will not be worth the hassle.  My game plan would be to buy back in when yields spike and they could spike by quite a lot. S&P was even recently taking about downgrading U.S. treasuries to AA status regardless of a debt ceiling negotiation.  Yields will spike. I promise you and now you have to promise me to keep dancin'

Steven J.
  

The Road to Default: Debt Ratio Comparison's With Previous Episodes

In 2009, Carmen M. Reinhart and Kenneth S. Rogoff wrote a book titled ,"This Time Is Different" about debt and financial crisis. One of their charts will provide a benchmark for us in our analysis.  This chart can be found on page 121 of the book and shows the ratios of public debt to revenue immediately preceding an external default.  For Africa the external debt/ revenue ratio was 1, Asia it was 1.5, in Europe it's 1.6ish and for Latin America its closer to 3. As the following chart explains our current ratio in the United States is around 1.7ish which is higher than in Africa, Asia and Europe at the time of an external default.

Additionally the chart in "This Time Is Different" also compares the ratios of total debt to revenue at the time of the default.  For Africa is was 2.6ish, in Asian countries the ratio lies around 4, in Europe it hovers around 3.75 and for Latin America around 4.6ish. As the following chart shows, we are considerably past this doomed territory with a public debt-to- revenue ratio of around 5.61 and climbing. The following graph I did in R because it just seemed easier. 

 So the lesson's learned today are that by history's benchmarks the U.S. is way past the point of no return and all we can do is hold on for the ride of a lifetime or prepare for the Federal Government to cut spending by a large enough amount that real GDP growth will most likely slow to a stall. It's a lose-lose situation. Prepare for pain, but keep dancin',

Steven J.

The Road to Default: We Crumble Like A Cookie

What should we be expecting when the United States defaults and how will this unsavory process unfold? Well for one thing anticipate the downfall with a downgrade in the credit rating.  According to recent Bloomberg article in the event of a U.S. default, Standard & Poor's would lower its sovereign top-level AAA ranking to a D, and Moody's would lower it to the Aa range.   The lower credit rating's would be absolutely disastrous for the bond markets because corporate bonds usually move in sync with treasuries and a default would lead to a sudden reversal of this standard procedure.  In the graph we compare interest rates on Moody's Aaa Seasoned Corporate Bond's with both the 3 year and 10 year treasuries.  Notice that Moody's rates are currently around 5% and we're now paying below 1% on our three year treasuries.  Now logically consider if Moody's downgrades our debt to Aa status- in the best case scenario we see a rise by at least 4-5% in interest rates.  Why will the rise be so sudden? Many insurance companies and pension funds, by internal mandate, hold only the absolute safest of securities. This means AAA only ratings are allowed.  Once treasuries get slapped with a lower rating- these funds will be forced to sell causing a massive decline in bond prices and an unprecedented spike in interest rates.  This spike in interest rates would make the most liquid market on the planet freeze up causing both a financial crises and a political one as well. For one, medicare and social security payments would have to stop. Second, treasuries are held on banks balance sheets as collateral, if they lose an unprecedented amount of value, we could see a banking crises as even cautious institutions may find themselves in an unhealthy cash position. Even U.S. credit defaults (CDX North American Investment Grade Index) swaps have climbed to their highest level since October! This is certainly not the beginning of this story, but it ain't over till the fat lady sings.


keep dancin'


Steven J.

The Road to Default: Let's Look at the Damage with a Rant.

The following graph shows Real GDP as a percentage of the Gross Federal Debt.  FRED is the resource I frequently use for United States financial data and it serves us well here.  


What is Gross Federal Debt? Well, its total government debt outstanding- including all the various agencies. 
Why do we compare real GDP with it? We want to hypothetically see that even if we have a 100% tax rate  for one year and kill every business we still couldn't eliminate all of our Government debt! 
Notice that we are at above 100%! Default is inevitable! Raising taxes (aka revenue) is frivolous at this point, the only way to bring this unsustainable rise in debt down it to deleverage by way of default.  This is the only way because our politicians are resolved to not do anything and to see what happens. Their lives are more important than ours and that is why they may refuse to engage in political blasphemy (cutting medicare, down sizing social security payments, ending unemployment benefits). 
The Republicans & FOX NEWS will blame the default on President Obama and John Stewart, no matter how ridiculous and untrue that may be. 

The Daily Show - Oh, for Fox Sake - Stewart Eviscerates Stewart
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 The Democrats will blame it on the Republicans refusal to come to a deal sooner.  In the end both will be severely discredited. I will blame it on our political system. It dooms us. How can anyone make a politically unpopular decision when they are worried about getting re-elected? They can't and they won't most likely.  Our country is in trouble and it's not because Casey Anthony was found not guilty, that we don't allow drilling in the gulf, or that we have millions of illegals pouring over the border.  It's not the small and meaningless stuff.  It's the structure of our broken system, the stubbornness of our elderly, and most importantly it's a failure to be truthful and do what's right.  

A few words from a recent speech by my main man, Benny B:

"The nation's long-term fiscal imbalances did not emerge overnight. To a significant extent, they are the result of an aging population and fast-rising health-care costs, both of which have been predicted for decades. The Congressional Budget Office projects that net federal outlays for health-care entitlements--which were 5 percent of GDP in 2010--could rise to more than 8 percent of GDP by 2030. Even though projected fiscal imbalances associated with the Social Security system are smaller than those for federal health programs, they are still significant. Although we have been warned about such developments for many years, the difference is that today those projections are becoming reality."

We have a severely flawed tax system that would cause no uprise if only it was consumption based, a financial system that gets drunk every year off new financial innovations and lack of regulation, and media that "tells" the truth- even when they lie. I'm not a religious man, but God help us! 


Keep Dancin'


Steven J.