Deficits and Interest Rates.

The following graph (via Business Insider) shows the yield on the 10 Year Treasury (blue) relative to the Total Public Debt (red):

I point this out now as the calls for reigning in government spending are getting louder.  It seems the primary reason why spending hawks do not want any more monetary stimulus is that it could move interest rates higher.  However, as the graph shows, and as the article points out, there is no connection between spending and interest rates.

I have an idea of why this is happening – deleveraging (see here, here, and here).  Basically as people begin to save more and pay off debt they spend less.  The decrease in spending affects the whole economy as individuals, financial institutions, and companies begin to save and hold cash.  Not wanting to take on risk, the cash is invested in Treasuries.  Thus, lower yields.

I have advocated for more fiscal stimulus numerous times.  While I do think longer-term – after the deleveraging cycle winds down – federal spending needs to be cut down, doing so now would make things worse.  In the words of Richard Koo:

“The insistence that fiscal consolidation is necessary in the longer term is like the doctor who, faced with a patient who has just been admitted to the intensive care ward, repeatedly questions the patient about his ability to afford the treatment. This is both lacking in decency and irresponsible.

If the patient loses heart after learning the cost of the treatment, he may end up spending even longer in the hospital, leading to a larger final bill. Completely ignoring the policy duration effect of fiscal policy and constantly insisting on longer-term fiscal consolidation was what prolonged Japan’s recession.”

What now with the “Fiscal Cliff?”

So I explained what the fiscal cliff is and why it is bad, but what will ultimately happen?  I have no idea, trying to figure out what a bunch of politicians are going to decide seems like a fool’s game.  Who can predict that?

Still, what we can try and do is estimate probabilities.  Now, I am not a forecaster, but I can give you the good news – the CBO says the forced austerity would probably throw the economy into recession.

Why is this good news?  Well the severity of going over the“fiscal cliff” is severe, so my thought is reason will dictate the discourse and if reason fails there is the insurance that these politicians like to keep their jobs.  I would actually bank more on the latter.   

Further, the two big items are the Bush tax cuts expiring and the “sequester”, there seems like a natural compromise here.  Republicans get the tax cuts, Democrats get to push back the automatic spending cuts.  Maybe the stimulus measures don’t get renewed, but hopefully the Bush tax cuts staying and "sequester" leaving will be enough to keep this 2% growth train moving!

Here is how Goldman Sachs econ team handicaps it:

1. 35% chance of temporary expiration of growth policies in 2013
2. 40% chance of short-term extension of growth policies with longer-term solution in later 2013
3. 20% chance of extension of growth policies for more than a year
4.  5% chance of “grand bargain” of fiscal and tax reform

The problem with the above (as with Europe) is that temporary measures are just that and create even more uncertainly.  Still, the above paints a 65% chance of outcomes I believe would be intermediately (through Q2 2013 maybe) good for the market, of course absent any exogenous shocks.

At the end of the day, I think the “fiscal cliff” big risk parallels another one of my big risks – Europe.  That is to say, the severity of the situation should yield at least a semi-positive result (I hope).  Still, the risks are large, real, and should be met with caution.  My other big risks are much harder to handicap – war Iran (seems low, but who knows) and a Chinese hard landing (black box).

Spending? Yes Please

Bill Gross is one of the best bond managers around, so it’s always comforting when someone as astute as Gross is on the same page as you.  In a prospectus for his clients (via TPM), Gross said:

“Solutions from policymakers on the right or left, however, seem focused almost exclusively on rectifying or reducing our budget deficit as a panacea… Both, however, somewhat mystifyingly, believe that balancing the budget will magically produce 20 million jobs over the next 10 years.”

In a previous post I highlighted my concern with spending cuts in regard to the market.  Broadly speaking, with the consumer being over leveraged and unemployment still high, where is the incentive for the private sector to invest? 

My concern is that if government doesn’t continue to spend the private sector can’t and won’t pick up the slack.  Further, if the government stops spending, how does that help the economy now?  I have difficulty finding the logic in that argument. 

Gross has a solution:

“Government must step up to the plate, as it should have in early 2009. An infrastructure bank to fund badly needed reconstruction projects is a commonly accepted idea, despite the limitations of the original "shovel-ready" stimulus program in 2009."

That seems good to me – put people to work, build critical stuff we need, employee people to do it, stimulus is pumped directly into where we need it, and the infusion gets the economy to the point where it is self-reinforcing.

Quick point, fiscal stimulus – cash injected to directly into the economy – is different than QE – where cash goes to fuel speculation.  I vote for the former and against the latter.

The Debt Deal is Done – Yay

I am glad a deal got done, but I am not yet willing to throw a party with magicians and piñatas. 

I will start good news:

• We won’t default, which I viewed as political issue, not a solvency issue.
• The spending cuts won’t be drastic and immediate like Greece.   

And now the bad news:

• The USwas still get downgraded, although I am not sure how bad this actually is for interest rates.
• It showed how poorly we are governed.  I don’t think anyone in Washington came out looking good after this.  Politicians took something simple and necessary and turned it into a school yard name calling contest.
• The deal signifies any future stimulus is probably out of the questions.  As I have mentioned before I think short-term spending is still needed. 

I think how you evaluate the deal depends on your perspective.  If you evaluate it on a possible catastrophe being avoided then it’s a huge success.  However, if you take Armageddon out of the equation as I did (I never thought we would reach that point), the apparent removal of fiscal stimulus from the equation is not a good thing.

Note:  I didn’t mention anything about long-term fiscal health because I couldn't find an objective point of view.  So if you find one feel free to forward it along.

What is the “Fiscal Cliff?”

I decided to do this series because a friend of mine asked why Fed Chairman Ben Bernanke was warning Congress about a “fiscal cliff.”  Coincidentally that afternoon I found an article discussing the “fiscal cliff” and its ramifications, so I decided to do some digging.

The “fiscal cliff” refers to the end of many stimulus tax measures (payroll-tax cut, investment tax credit, enhanced unemployment insurance), the Bush tax cuts, and automatic spending cuts called “sequester” at the end of 2012.  It is automatic austerity.  Here is a rundown:

• Tax Increases
• Under status quo at the end of 2012 roughly 42 tax benefits will expire at the end of 2012.  (Source 1)
• The 2001 and 2003 tax cuts are set to expire. This includes tax rates on those making over $250K as well as qualified dividends and in particular the 15% rate on long term capital gains.  (Source 2)
• The Payroll tax cut will expire at the end of 2012, increasing from 4.2% back to 6.2%.  (Source 2)
• The Alternative Minimum Tax (AMT), currently at 28% for those filing jointly with incomes of $74K or greater, will drop down to $45K.  (Source 2)
• Numerous temporary research and development tax benefits to corporations will expire.  (Source 2)
• Spending Cuts
• Automatic, across-the-board cut in domestic and defense spending, called the “sequester”, takes effect, cutting about $100 billion from government spending next year. (Source 3)
• Unemployment benefits for workers who have exhausted the standard 26 weeks of benefits will be phased out. (Source 2)
• At the end of the year the infamous debt limit will hit again, potentially forcing further cuts. (Source 2)

In my next post, I will discuss why this is bad.

Source 1 – Lance Roberts and David Rosenberg.

Source 2 – Walter Kurtz and Goldman Sachs.

Source 3 – The Economist. 

Even the Best are Struggling

Many successful bond managers have had an off year in 2011, the most prominent being   Bill Gross, who recently issued a “Mea Culpa” for his poor performance. 

The same can be said for some equity managers, who have until this year had very good long-term results, for instance John Paulson and Bruce Berkowitz. 

As I already commented, picking a manager based solely on past returns can really get you burned.  It is more important to look at the process, whether or not it’s sustainable, and recognizing AND acting when it’s time to make a change.  (Note:  I am NOT recommending selling any of the above managers, just pointing out their poor returns as of late)

However, the lackluster performance by some of the industy’s best managers who had previously shattered their respective benchmarks points to how hard it has been to invest in the current market environment, due in part to the following:

• Continued consumer deleveraging
• Massive monetary and fiscal stimulus and then the removal of the stimulus
• Credit markets collapsing, then repairing, and now skittish again
• Emerging markets increasing importance and then the subsequent possibility of overheating
• Eurozone struggles  

So if the best are struggling, how can the average investor help weather the storm?  Here are some tips:

• Don’t make big bets , and don’t rely too much on one manager – avoid concentration risk by diversifying
• Develop escape routes before investing
• Take risk off the table when you get queasy
• Avoid drastic moves - if you make moves one way or the other, keep it small
• Hedge when and where it’s appropriate
• Don’t get emotional

1937, or Why I Want More Short-Term Spending

I have mentioned on many occasions that I think the Federal Government should increase stimulus spending in the short-term.

And in my last post I outlined how the Feds tightened monetary policy and decreased spending in 1936 and 1937.  So here are a couple consequences. 

• GDP sank:

•  The unemployment rate went from 9.2 in 1937 to 12.5 in 1938. 

With a quick glance at my previous post, you can see when spending picked up both GDP and unemployment started to look better.  The money supply also increased again.  

Now is it possible the monetary and fiscal contraction were not the cause of the 1938 recession?  Or that maybe only monetary or fiscal policy matters?

Of course; however, given the past fallout from such contractionary policies I don’t believe it is prudent to do either at this moment.  This is especially true since inflation and interest rates are low.  As such, the risk/reward trade-off of cutting back seems heavily skewed toward risk.