US Federal Debt

[Eric50]

Eric Sprott's latest letter is a must read. The coming funding crisis might be huge.... Personally I've never been so worried about the future of the US and world economies.

 

Eric

 

http://www.sprott.com/Docs/MarketsataGlance/June_2009.pdf

[Guest Broxburnboy]

Although he seems alarmist about the looming crunch, Sprott's previous prognostications have been correct, if somewhat early. He's like Prem who saw the credit bubble coming and hedged accordingly. Sprott, however sees gold, other precious and base metals and agricultural commodities as the safe refuge to withstand the collapse of the US economy.

The bottom line is that recent Fed and government manouverings have not cured anything, but rather forestalled and worsened the imminent crunch. Too much debt can not be cured by incurring more.

I wonder where Prem is sticking FFh's equity these days... he can't be blind to the US bond bubble that's about to pop. California is shortly going to lay off a large proportion of its employees and suspend spending... this may be the catalyst for another leg down in the housing and credit markets.

Personally I have bought into Sprott's vision and have been buying SII (tsx), so that I have most of my own equity in the care of Sprott and Prem.

The other guru whose vision I trust is Jim Rogers  who offers a different scenario where stock prices may actually increase, but denominated in currencies whose value has diminished. Rogers sponsors an agricultural commodities ETF ...RJA that is worth a look as a store of real value.

Sorry to be such a downer, but I am seeing light at the end of the tunnel...and its an oncoming train.

[JAllen]

Zimbabwe's stock market went up 12,000% during their inflationary (to say the very least) period.

 

I have one of their 5,000,000 notes that wouldn't buy a loaf of bread; and that was a year ago.

[Smazz]

Zimbabwe's stock market went up 12,000% during their inflationary (to say the very least) period.

 

I have one of their 5,000,000 notes that wouldn't buy a loaf of bread; and that was a year ago.

you def have bigger cohones than I.  I wouldnt go near that stuff.

[ragnarisapirate]

Zimbabwe's stock market went up 12,000% during their inflationary (to say the very least) period.

 

but that is nothing when compared to their inflation rate that is in the millions of %

[scorpioncapital]

Nice article. The one assumption I'd like to question is if the budget must be balanced in any given year to exactly zero. Does the government need $1.6 trillion this year or can it raise less and carry-over the deficit to the next year?

 

 

[vinod1]

Nice article. The one assumption I'd like to question is if the budget must be balanced in any given year to exactly zero. Does the government need $1.6 trillion this year or can it raise less and carry-over the deficit to the next year?

 

All Govt spending (every single dollar spent by Govt) has to be supported by one of the following

1. Taxes

2. Debt (T Bills, T Notes, T Bonds sold)

3. Printing Money

 

Deficit is by definition funded by 2 & 3. The Govt has to fund the $1.6 trillion via #2 and #3 this year.

 

Vinod

 

[vinod1]

You can add in the occasional asset/license sales by Govt but that is usually not a significant factor for US.

 

Vinod

[NormR]

You can add in the occasional asset/license sales by Govt but that is usually not a significant factor for US.

 

I hear they'll provide vendor financing to anyone willing to take California off their hands.  ;)

[Cardboard]

Is the situation as described by Sprott really that simple? Is there any hole in his analysis? I mean, if it is that simple and the timing is truly before the end of 2009 then why is it that the market is not panicking yet?

 

While I believe that the situation is very difficult and that something could easily go wrong, I am not 100% certain of it. It would be nice if we could find a security that would provide a hedge against such event at a very small cost. For example, Prem was able to buy credit default swaps to hedge against the credit bubble at a very small cost relative to Fairfax portfolio, but with tremendous upside. The downside was also limited to the cost of the CDS.

 

Essentially, you need something to bet against long term treasuries or the dollar, but that something needs to be cheap or not recognized yet as of much value to the marketplace. Calls on TBT? Some kind of interest rate derivative? A call on silver? Any other idea?

 

Cardboard 

[vinod1]

Is the situation as described by Sprott really that simple? Is there any hole in his analysis? I mean, if it is that simple and the timing is truly before the end of 2009 then why is it that the market is not panicking yet?

 

While I believe that the situation is very difficult and that something could easily go wrong, I am not 100% certain of it. It would be nice if we could find a security that would provide a hedge against such event at a very small cost. For example, Prem was able to buy credit default swaps to hedge against the credit bubble at a very small cost relative to Fairfax portfolio, but with tremendous upside. The downside was also limited to the cost of the CDS.

 

Essentially, you need something to bet against long term treasuries or the dollar, but that something needs to be cheap or not recognized yet as of much value to the marketplace. Calls on TBT? Some kind of interest rate derivative? A call on silver? Any other idea?

 

Cardboard   

 

The only thing I can think of is a non-dollar denominated Sovereign Inflation Protected Bond. Something like the ETF, WIP may provide this protection. But it does not have options, so it would not be possible to lever up with a small amount of money.

 

Klarman also mentioned about having bought a low cost inflation protection investment, so his portfolio may provide some guide.

 

Vinod

[Nnejad]

Sprott's argument is too simplistic, see the following example:

 

If US borrows 2 trillion, it is to spend two trillion, meaning two trillion dollars reaches the hands of other US persons or institutions.

Monetary velocity hovers around 1.5.  So that means of that two trillion, persons/instituions will spend .7 trillion, and save 1.3 trillion.  Already, we have found a source for much of the net increase.

Now of the .7 trillion spent, it is again distributed to other members of the economy.  Monetary velocity is 1.5, so .2 trillion is spent, .5 trillion is saved.

So net result, is the US government borrows two trillion, and 3 trillion ends up being spent, and two trillion remains to be saved or invested.  Since people are risk-averse, much of that will end up in government debt. 

 

The Sprott's of the world are dangerous, although not for the reasons they think.  It's not a panic that's worrisome; the government can print money to start the process going.  But by causing fear, he is really risking:

a)changing people's habits and thus reducing their spending and monetary velocity going forward;

and b) inhibiting the will for private investment to return.

Which lowers the long-run growth of a country.

 

Nothing to fear but fear itself, they say.  And in war, I've heard nothing defeats the country quite like demoralizing the will and spirit at home.

[Mungerville]

Hoisington believe we have deflation not inflation.  Watsa seems to be playing the reflation trade but believing deflationary forces will be greater than the market expects.  He seems to be playing this thing almost like a contradiction.  Its not simple at all.

[Uccmal]

The argument is way too reductionist.  A portion of the money that is borrowed, or created, will be spent on Stimulus packages.  Workers will be paid.  In turn they will pay taxes.  Should the stock markets rebound somewhat in the meantime there will be billions (or trillions) in Capital gains taxes.  People will pay taxes on the gov't bond interest.

 

Worldwide, workers are in savings mode.  This means that eventually the money will seek higher returns which will lead to the inevitable rise in stocks and the associated capital gains. 

 

If inflation becomes rampant then the debt will quickly devalue and become easier to pay back.

 

If the money is well spend there may actually be value added.  Fixing the NA transmission systems would reduce future costs.  Spending money on more disagnostic imaging machines for all will reduce the amount spent on health care later.  ETc, Etc, Etc. 

 

Buffett and FFH have spent money on companies that are clearly tied to the success of the US economy such as USB, USG, WFC, GE, and GS.  Prem has even stated that they are not concerned about inflation in the near to medium term (AGM).  And they follow Grant, Van Hosington, and Grantham. 

[Guest Broxburnboy]

"If US borrows 2 trillion, it is to spend two trillion, meaning two trillion dollars reaches the hands of other US persons or institutions."

 

This would be true if the money was invested and created a return. But the debt accumulated has no return. Debt is not a problem until you lack the means to pay it back... then it becomes a problem for both the creditor and debtor.

 

If your statement were true, then the US government could simply borrow from itself and give the money to its citizens and presto.. instant wealth. We could import all our needs and rack up unlimited debt so why work?

Such a scenario is absurd, the US is actually in the position of any debtor with a cash flow problem, trying to borrow money to pay off yesterday's loans and new debts it has acquired through "bail outs" and deficit spending.

 

Progress will begin when the deficit is eliminated by higher revenues (taxes, fees), cutting non essential spending (wars, big part of military spending), entitlements, direct subsidies to business and diluting the money supply by printing money.

[Guest Broxburnboy]

"Essentially, you need something to bet against long term treasuries or the dollar, but that something needs to be cheap or not recognized yet as of much value to the marketplace. Calls on TBT? Some kind of interest rate derivative? A call on silver? Any other idea?"

 

For US citizens, the best hedge may be to invest in a country whose currency should retain its relative value. Index funds or blue chips in China, Brazil etc. US stocks which have an international revenue stream should mitigate the dollar risk. GE, IBM etc.

The problem with CDS has always been counterparty risk, should the worse case scenario come to pass, the risk

of default will skyrocket.

[kvattiku]

Hi Cardboard,

  Klarman mentioned that he had bought interest rate caps and swaptions (as a hedge against inflation).. Please check the following article (towards end of page 3)

 

http://www.advisorperspectives.com/newsletters09/pdfs/Seth_Klarman-Why_Most_Investment_Managers_Have_It_Backwards.pdf

 

 

Essentially, you need something to bet against long term treasuries or the dollar, but that something needs to be cheap or not recognized yet as of much value to the marketplace. Calls on TBT? Some kind of interest rate derivative? A call on silver? Any other idea?

 

Cardboard   

[Nnejad]

"If US borrows 2 trillion, it is to spend two trillion, meaning two trillion dollars reaches the hands of other US persons or institutions."

 

This would be true if the money was invested and created a return. But the debt accumulated has no return. Debt is not a problem until you lack the means to pay it back... then it becomes a problem for both the creditor and debtor.

 

If your statement were true, then the US government could simply borrow from itself and give the money to its citizens and presto.. instant wealth. We could import all our needs and rack up unlimited debt so why work?

Such a scenario is absurd, the US is actually in the position of any debtor with a cash flow problem, trying to borrow money to pay off yesterday's loans and new debts it has acquired through "bail outs" and deficit spending.

 

 

Run through your hypothetical example.  Let's say the US borrows 2 trillion, and decides to just give it to people (instead of the much better option of making them earn it).  Well now 2 trillion is in the hands of people with demand.  And they will either spend it (creating demand for work), or invest it.  Worst case, they're so risk averse they use it to buy the treasuries back, and its a net zero in stimulus. 

But more likely; those people will create demand, and so work and investment.

 

Normally, such a move by government would require a high interest rate to draw money away from higher-return market alternatives.  But right now, no one wants money to spend or invest, and they're willing to give it to government for free just for the safety.  The only one left to step up is government.  The arguments for this are pretty well stated by Keynes.

[omagh]

Sprott is just regurgitating Bill Gross, but with an alarmist message.  Here's Gross' original:

 

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2009/IO+June+2009+Staying+Rich+in+the+New+Normal+Gross.htm

 

Paul McCulley, also at Pimco, indicates that the Fed can also shrink its balance sheet through asset sales and is not purely adding liabilities to its balance sheet.  Also, he provides some insight into the differences between quantitative easing vs credit easing.  McCulley also argues against "rip-roaring inflationary fire".

 

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/Global+Central+Bank+Focus+June+2009+Exit+Strategy.htm

 

Sprott's thesis is inflation and thus metals and commodities -- typical Canadian money manager stuff, sell what's in your back yard.  Sprott's probably still recovering from last year.  http://www.sprott.com/priceperformance.aspx?id=15&t=2

 

-O

 

Eric Sprott's latest letter is a must read. The coming funding crisis might be huge.... Personally I've never been so worried about the future of the US and world economies.

 

Eric

 

http://www.sprott.com/Docs/MarketsataGlance/June_2009.pdf

[omagh]

microvalue on another board shared an interview with Julian Robertson (ex-Tiger Fund) who contributes the following idea:

 

JR: There are a lot of things to do. The insurance policy I would buy is called a CMS [Constant Maturity Swap] Rate

Cap, which is the equivalent of buying puts on long-term Treasuries. If inflation happens the way it could, long-term

Treasuries are just going to explode.

[Editors’ Note: Tiger trader Pat O’Meara explains that the CMS Rate Caps are options to bet on interest rates rising for

10-year or 30-year Treasuries. He provides a current example, in which one could buy for $50,000 a five-year option, betting that

the yield on $10 million worth of 10-year Treasuries rises above 4.2% between now and expiration in 2014. Including the

0.5% cost of the option, the break-even yield level is 4.7%.]

 

Essentially, you need something to bet against long term treasuries or the dollar, but that something needs to be cheap or not recognized yet as of much value to the marketplace. Calls on TBT? Some kind of interest rate derivative? A call on silver? Any other idea?

 

Cardboard   

[arbitragr]

The problem with all this govt. meddling is that you get heaps of uncertainty.

So one could assume that we could get inflation when the govt. prints money, so you can short long term treasuries e.g. via TBT.

However the problem with "Quantitative Easing" is that the govt. is actually going out there and purchasing long term treasuries too, thereby pushing the yields of long term treasuries down, hence the value of TBT would go down.

However just as quantitative easing can produce inflation, the govt. can also control inflation by raising interest rates again, this would send TBT back up again, and commodities down.

Jim Grant doesn't like the Federal Reserve and thinks it should be abolished. I can understand why.

They're creating all sorts of untended consequences, whilst in the short term we are all sitting there scratching our heads.

[Cardboard]

Thanks a lot for the information on Klarman and Robertson guys.  :) I had gone through the 13F from Baupost to try to understand what Seth was using to protect from inflation and could not really find anything.

 

Wow! This is getting really interesting. Roberston is another one that did make a fortune betting heavily on CDS. We have a lot of players who anticipated the previous crisis now protecting themselves from something nasty occuring in the not too distant future:

 

John Paulson (CDS now into gold), Kyle Bass (CDS now into gold), David Einhorn (short financials now into gold), Julian Robertson (CDS now I assume into these CMS), Seth Klarman (heavy in cash now into these interest rate caps), Prem Watsa (CDS now into ?).

 

I am sure that I am missing quite a few more. Buffett is definitely another one that was prepared for the crisis with a mountain of cash and has now mentioned many times that he is worried about inflation.

 

These are all pretty level headed guys unlike Sprott and they all seem to come to the same conclusion or the need for some protection. Although, Sprott has been right on many things and I don't want to discredit him, he strikes me as a gold bug or one that will have a very hard time leaving the table at the right time.

 

On a related topic, I read this article yesterday.

 

http://money.cnn.com/2009/06/22/news/economy/derivatives_regulation_risks.fortune/index.htm

 

It makes me wonder about all these interest rate derivatives and the risk of some "miscalculation" by a player to hedge risk properly that could lead to some kind of domino effect. If interest rates spike a bit for any reason I wonder who is going to be left out there holding the bag? There must be another AIG or Bear Stearns in this world who is simply praying that this does not happen.

 

Cardboard

 

[prevalou]

Buffett is always worried about inflation. One day, he will be right!

[Guest Broxburnboy]

"Run through your hypothetical example.  Let's say the US borrows 2 trillion, and decides to just give it to people (instead of the much better option of making them earn it).  Well now 2 trillion is in the hands of people with demand.  And they will either spend it (creating demand for work), or invest it.  Worst case, they're so risk averse they use it to buy the treasuries back, and its a net zero in stimulus.

But more likely; those people will create demand, and so work and investment."

 

That's great, but to complete the circle, the money borrowed has to be repaid, either by return on investment (that's why it's stimulative to invest in infrastructure as opposed to handouts) or by taking the stimulus back (taxes). If the circle completes and the loan is repaid by wealth created ...its stimulative and non inflationary, if the loan is repaid by dilluting the currency, inflation results. If the unpaid debt is allowed to accumulate the result inevitably is credit impairment, delevering and eventual bankruptcy.

[Nnejad]

 

That's great, but to complete the circle, the money borrowed has to be repaid, either by return on investment (that's why it's stimulative to invest in infrastructure as opposed to handouts) or by taking the stimulus back (taxes). If the circle completes and the loan is repaid by wealth created ...its stimulative and non inflationary, if the loan is repaid by dilluting the currency, inflation results. If the unpaid debt is allowed to accumulate the result inevitably is credit impairment, delevering and eventual bankruptcy.

 

If an amount of money was at period 1 was being spent and invested, but now in period 2 is being held in cash, then that's severely deflationary.  You could borrow that money and distribute it, for free, and even finance it by printing currency, and it still wouldn't be very inflationary, as it is just taking domestic product to a level previously achieved.