Wednesday, June 23, 2010

Back At the Precipice

Like groundhog day, the U.S. and other Western economies are once again at the edge of the economic precipice. The nascent economic recovery is stalling out only 9 months since Bernanke declared the "end of the recession". Of course, for those 10% officially unemployed (17% when you include people who have given up on finding employment), the recession never ended. Wall Street as usual is in total denial, because the average expansion since WWII has lasted 40 months, so the piggies are not yet ready to leave the trough this early in the cycle when the consensus is that "there must be" more of that free money left in the Bernanke monetary punch bowl. Won't they be surprised.

Bear in mind that this depressionary relapse is occurring despite policy-makers having applied unprecedented levels of stimulus, both fiscal and monetary. The Federal deficit this year is 10% of GDP (~$1.5 trillion), which means that the Federal government has to borrow 30 cents for every dollar it spends just to propagate the illusion of recovery !!! That is a staggering fact: 10% unemployment despite a 10% of GDP deficit. And yet there are two moronic camps that keep arguing one on the side for more fiscal stimulus and the other on the side for fiscal austerity. These are like two fat bald men fighting over a comb on the deck of the Titanic. The mere fact that the economy is stalling out, despite a 10% GDP deficit means that fiscal stimulus at the margin is no longer working, because it has been overused. This chart below shows the marginal growth effect on GDP from an additional $1 of debt - it's now less than $.20 on the dollar ! Game over, man !

On the other hand, contrary to the tax-fearing "Tea Baggers", none of this money is EVER going to be repaid anyway, since basic math indicates we would need to grow the economy by 30% (assuming no changes to tax rates) just to eliminate the deficit, to say nothing of paying down the additional trillions in debt that will accumulate in the meantime.

So, despite and because of the Federal Reserve giving out free money at 0% and the Federal Government borrowing a third of its annual budget, policy-makers are now completely out of ammo. Even as fresh signs of renewed downturn abound, in the recent horrendous housing numbers, pathetic employment figures, and leading economic indicators , which are all pointing down.

But you don't need fancy data to tell you the economy is slowing. Just today, the yield on the 10-year Treasury bond reached 3.11%, a level it has only touched twice since 1962 ! i.e. bond markets which are usually concerned with inflation are signaling that fear of inflation has left the building. In line with that sentiment, Bill Gross from Pimco (world's largest fixed income management firm) speaking on CNBC admonished the Fed to state that they will keep interest rates exceptionally low for an "exceptionally long" period of time i.e. keep the free money flowing and love me long time Sugar Daddy. No conflict of interest there at PimpCo.

Meanwhile, those few economists lucid enough to even consider a "double dip" recession are just rearranging deck chairs on the fat man's Titanic. Sure, unlike the rest of their irretrievably clueless brethren, they at least have a latent sense of impending downturn, and yet these few are still too conventional in their thinking to realize that the economic ship is already keeled over at 90 degrees and getting set to sink inexorably to the bottom.

And that is the state of the U.S. economy. Hard to imagine that Europe is as bad or worse. Several well known European countries are on the verge of sovereign debt default and one does not have to be a genius to figure out that it will only take one default to fell the others like dominoes. All of these countries (as does the U.S.) rely on well-functioning credit markets to rollover their debts on an ongoing basis. Once risk aversion sets in and interest rates rise beyond a certain point, then default becomes inevitable as the deficit/debt service burden becomes too large and unmanageable. As stated before, it's only because the U.S. dollar is the world's reserve currency and hence the only viable safe haven from a liquidity standpoint, that allows the U.S. government to pursue the profligate path versus the austerity path being forced on Europe. Of course at some point, the U.S. government debt ponzi will collapse as well, when investors repudiate U.S. debt and the dollar, but that will likely be *some time* down the road closer to the end of the deflationary cycle that is still just getting underway.

For those looking to protect their assets through the deflationary cycle, here is what I recommend. And yes, TLT (long-dated Treasuries) are still outperforming well. Even Pimco recently got back onboard the Treasury wagon.

[FYI, for more insight on deflation, Robert Prechter (EWI) recently gave an excellent interview for the web site "The Daily Crux" which you can read for free here]