Vigilantes and Deficit Hawks are Extinct; Stocks love DEBT!
By Victor Sperandeo with the Curmudgeon
In the mid-1980s, the term “bond vigilantes” was widely used. It referred to large bond investors who would sell their holdings in an effort to enforce fiscal and monetary discipline. That in turn would increase bond yields, making it more expensive for the U.S. government to borrow (due to increased debt service cost). At the first sign of fiscal or monetary backsliding, bond vigilantes would sell in massive quantities which would lift real yields to heights that would stop the economy cold. The politicians would ONLY then make the appropriate policy adjustments to reduce spending and deficits. Such was the vigilantes’ belief.
“Deficit hawks” are U.S. Congress members who emphasize limitation of the federal budget in order to control the national debt. They advocate reduced government spending in order to reduce (rather than balloon) U.S. government budget deficits.
Sadly, both of these entities have disappeared.
Bond vigilantes would’ve sold bonds in mass when Bernanke started ZIRP and QE monetary policy.
Deficit hawks would not have tolerated the budget busting GOP tax bill in late 2017 that has produced a budget deficit this fiscal year that will approach or slightly exceed $1 trillion! They would also have not agreed to the July 21, 2019 “deal” with the Trump administration on a two-year budget that would raise spending by $320 billion over existing caps. More on the impact of that later in this article.
“It’s pretty clear that both houses of Congress and both parties have become big spenders, and Congress is no longer concerned about the extent of the budget deficits or the debt they add,” said David M. McIntosh, the president of the Club for Growth, a conservative group that advocates free enterprise.
The federal debt has ballooned to $22 trillion BEFORE this deal becomes law. Despite healthy economic growth, the federal deficit for this fiscal year has reached $747 billion with two months to go — a 23 percent increase from the year before.
“It appears that Congress and the president have just given up on their jobs,” said Maya MacGuineas, the president of the Committee for a Responsible Federal Budget, which blasted out a statement arguing that the tentative deal “may end up being the worst budget agreement in our nation’s history.”
NOTE: The remainder of this article is written by Victor, with slight edits and Notes by the Curmudgeon.
Just the Facts:
In the 1950’s actor Jack Webb starred in a TV series called “Dragnet.” Webb played Sergeant Joe Friday, a stoic, poker faced detective, who often used the expression: “Just the Facts,” when he questioned people during his investigations.
Debt and Deficits Analyzed:
“Just the Facts” about the U.S. national debt, makes one wonder if it even matters? Let’s try to address that question.
This past Thursday, July 25th another budget was passed by the House of Representatives with an increase in spending of $320 billion over two years and no debt limit. The Senate is expected to approve the measure next week. That budget “deal” would raise spending by hundreds of billions of dollars over existing caps and allow the government to keep borrowing to cover its debts.
This means an estimated total U.S. budget deficit of $2 trillion more by September 2021. Thereby, the U.S. official STATED DEBT will be an estimated minimum of $25 trillion, which does not include “Off Budget” items of more than $10 trillion or Unfounded Liabilities in the 100’s of trillions.
A $1 trillion deficit is about 5% of GDP per year. High, but not horrible in percentage terms, which is the only legitimate way to portray the deficit number when it’s in trillions of dollars.
Debt and deficits have been talked about as political issues, since Ronald Reagan was elected President in 1980. Ross Perot ran for President on the debt/deficits as the most important problem facing the U.S. That was when the U.S. gross debt was $3.6 trillion on 9/30/91 vs $22 trillion now.
In recent years, financial markets never seemed to care, or react, to increasing debt numbers. Astonishingly, just the opposite has occurred -the greater the spending and budget deficit, the more stocks rallied!
How is that possible? To me, it’s because the U.S. has a printing press based monetary system (check the Fed’s exponential balance sheet increase from the end of 2008 to late 2014) and it is on a “paper” foreign exchange standard (based on the full faith and credit of the U.S. government), rather than the gold standard we were on till August 11, 1971.
When FDR changed the U.S. Constitution on May 1st, 1933 (and the Supreme Court looked the other way by not adjudicating any of the pending lawsuits at the time) that was the end of Article 1 Section 8 clause 6 of the U.S. Constitution, which read:
The Congress shall have the power... “To Coin Money, and regulate the Value thereof, and foreign Coin, and fix the Standard of Weights and Measures.”
The key concept was “COIN” not print money! Further, when the U.S. went off the International Gold Standard (August 11, 1971), the gross federal debt was a mere $398,129,744,655.54 ($398 billion) as of on June 1971. However, as of September 30, 2018 (the 2018 fiscal year end) it was $21,516,058,183,180.23 ($21.5 trillion).
That means in 47.25 years, the compounded increase in the gross U.S. Debt was 8.81% per year, while Real GDP grew at 2.75% and the CPI at 3.91%.
· The eye-popping result is that U.S. debt is growing at 3.2 X’s GDP!
· Interestingly, the S&P 500 compounded at 10.3% in the same time period that U.S. debt was exploding!
· The CPI in the last 10 years ending June 2019 was only 1.73% or 44% of the amount from 1971.
The evidence suggests: stocks love debt!
The past decade has seen an incredible increase in federal debt even as benchmark Treasury yields are decisively below levels that prevailed for much of the Great Recession. One is compelled to ask if debt levels (or more to the point, deficit levels) have any power to explain bond yields?
It’s probably not a coincidence that the sensitivity of U.S. Treasuries to deficit and debt levels has declined as the role of overseas foreign-exchange-reserve managers has increased in recent decades. China and Japan have been huge net buyers of U.S. treasuries with their trade surplus dollars. As of May 2019, each of those Asian countries owned over $1.1 trillion in U.S. Treasuries. You can view all major foreign holders of Treasuries here.
The Fed’s Recent Monetary Policy - Not Good:
M2 Money Supply grew at 6.15% ($8,430.7 trillion to $13,128.0 trillion) from June 2009 till November 7, 2016 (when Trump was elected President), according to the St. Louis Fed.
Yet under the Trump administration, M2 has grown at an extremely low 4.2% or 32% less than in Obama’s Presidency! The reason is that the Fed’s Balance Sheet declined by -6.58%, compounded annually, from 11/7/16 to 5/6/19 or 2.5 years ($4,512,936 trillion to $3,808,110 trillion).
This guarantees slower growth and inflation (from 11/7/16 to date) with the typical year and half lag. The CPI was only 1.65% in the last 12 months YoY.
The Fed claims they want to “normalize” their balance sheet to be prepared for the next recession, which they will likely cause by their “quantitative tightening” policy (aka Balance Sheet Runoff, as we explained in this post).
Looking back to post WWII or from the late 1940’s, there is no other period over one year much less over two years that I could find which had a decline close to these numbers.
It is highly likely a recession will occur without further fiscal stimulus or a big change in monetary policy. I wonder if Milton Friedman is kicking in his grave over the Fed’s recent monetary policy.
On July 26th, 2nd quarter GDP was reported at 2.1%, which was better than expected, but well below 3.1% for the first quarter. Consumer expenditures rose 4.3% while business investment slumped 5.5%.
The world economy is slowing as everyone knows (check how many times the IMF and World Bank have lowered their economic growth forecasts for this year and next). I don’t think U.S. GDP will be influenced by a 25 bases point Fed interest rate cut on August 1st, as it is a lagging monetary policy tool. But it does drive confidence, so stocks always react positively to the Fed lowering the Fed Funds rate. The U.S. economy will not have much of a reaction, in my humble opinion.
The empirical evidence and conclusions are obvious:
· In the short run the Fed is King, especially for a stock market that repeatedly celebrates the discounting of the same news over and over and over again (see Curmudgeon Rebuttal to Ray Dalio in last week’s post).
· “Sovereign Debt” does not matter in the short and intermediate term, because the Fed backs the debt with an unlimited printing press.
· Without a Federal Reserve System, the government could never borrow this debt.
It should also be understood that since 2014, commercial and investment banks have materially changed their rules. So now instead of the Fed, the banks are the primarily printing force of the U.S. currency, and the provider of credit to borrowers.
Every time banks buy U.S. government debt they create an arbitrage for themselves! The rules have changed to make selling of government debt a very profitable and risk-free business for the banks.
As a result, the banks have been the buyers of virtually 100% of the newly issued federal debt this year.
See my article The Rules of the Bond Game for how this works. Here’s an excerpt:
The really interesting part is (banks) skirting around mark-to-market accounting, though. Since the banking crisis, banks have been permitted to hold assets in a special account called an HTM account, which stands for held to maturity.
Government debt held in this account is not marked to the market. So even if interest rates rise and the prices of the bonds fall, the bank reports no decline in the value of the debt, which means no negative effect on quarterly earnings. But it still gets to collect the interest. Since early 2014, CBs have been routinely shifting greater and greater portions of their government debt into these HTM accounts, avoiding accounting for any mark-to-market losses entirely.
It’s a complex formula to follow through the different Treasury and Fed accounts, but in effect, government debt is considered risk-free and therefore can be held without reserve or capital requirement, and without mark-to-market risk. That is because it falls under the applicable guidelines that meet the description of the Basel Committee of the Bank for International Settlements.
End Game for Debt?
So what is the end game for the Monopoly Debt Game? It’s in the quantity of “interest” payments, which will become the largest component part of the total budget in 10 years, in my view.
As of January 2019, the CBO projects “interest payments” in 2029 to be $928 billion. That is without a recession for the next 10 years! And that’s on top of the longest (10+ years) economic expansion in U.S. history!
Please note that the U.S. budget deficit will grow to $3 to $4 TRILLION PER YEAR -FOR 2-3 YEARS in the next recession if you interpolate the consequences from 2008.
As interest rates decline, more debt will be created because paper money is borrowed and printed. As interest rates drop, gold becomes more competitive with low/negative interest paying debt.
The world has 13 trillion Euros of negative yielding debt! Gold in terms of the EURO is up 15.9% this year vs gold in U.S. dollars which is +11.3%.
Increasing deficits and debt causes all currencies to decline (it’s a “race to the bottom” for global currencies). It will eventually create more inflation and (in theory) higher interest rates.
Government debt under the current system (and all things being roughly equal) will always be funded with printed and/or borrowed currency from the Fed and the banks.
It is the quantity of the Vigorish (Vig) interest [1.] that will doom the debt. Why? See the underworld’s method of loaning money and collections for a paradigm.
Note 1. Vig interest is the charge paid on a bet to a bookie or on a loan to a usurer. It is interest a loan shark charges.
If you borrow and repay the principal and Vig on time you can always borrow more. However, you better have lots of medical insurance (POW!) if you repay the principal and want to borrow to repay the interest!
As long as the interest paid is substantially less than U.S. taxes collected the game can continue. Interest today is about 11% of tax collections (federal government revenue). If interest paid is 50% of total taxes collected, we should all be on alert.
All the empirical experience points to the long run (5-10 years) as the debt timeframe to worry about. In the short run, debt and deficits apparently do not matter but it certainly looks like a ticking time bomb!
It should be in the forefront of all government dictates to remember this axiom:
“TO the States, or any one of them, or any city of the States: Resist much, obey little; Once unquestioning obedience, once fully enslaved; NO Nation, State, City, of this earth, ever afterward resumes liberty.” Walter Whitman
Good luck and till next time……
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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