Houston, We (May) Have A Problem!

Source: www.stlouisfed.org

Above is a chart of the US’s total public debt as a percent of GDP. As of Q2, the ratio was at 100.5%. According to current estimates, the debt to GDP ratio is now at 106.5% and rising. This puts the US in some select company with a debt to GDP ratio over 100%. According to the most recent figures provided by www.tradingeconomics.com  Japan leads the way at 212%. Japan is followed by Greece (157%), Zimbabwe (151%), Jamaica (146%), Lebanon (140%), Italy (127%), Portugal (124%), and Ireland (118%). The US is number nine. The Euro zone is collectively at 91%, while the United Kingdom is also at 91%. Canada sits at 84%. Down near the bottom is Russia at 8.4% and China at 23%.

Some of the countries with a debt to GDP ratio over 100% are effectively economic basket cases. This highlights the debt problem as the US heads into the debt ceiling collision that has dominated the news since the beginning of October. The US debt to GDP ratio has gone from around 70% prior to the 2008 financial crisis to over 100% today.

The US debt is estimated to be approaching $17 trillion. In theory, this should already be over the debt ceiling of $16.7 trillion. With a debt to GDP ratio in excess of 90% economists Carmen Reinhart and Kenneth Rogoff have estimated that it lowers growth rates by at least 1% annually. Given that all of the major western economies have debt to GDP ratios in excess of 90% growth is constrained and is most likely to continue to be constrained going forward. Japan with a debt to GDP ratio in excess of 200% has been in a two-decade plus rolling recession with no sign that it is about to come out of it

With the exception of Japan, all of the above noted countries with debt to GDP ratios over 100% are experiencing severe recessions or are in economic depressions.  Because of Japan’s unsustainable debt to GDP ratio north of 200% there are many who believe that Japan may have no choice but to enter into a structured default. If Japanese interest rates were to rise to 3% Japan in theory could be paying its entire budget to service its debt. Against this background, some are questioning could the US be next. For the US just a 1% rise in interest rates could add in theory an additional $170 billion to the national debt each and every year. No wonder the US wants to keep interest rates low.

The “shutdown” is one thing. The US can limp along. While there most likely could be inconveniences (some of them more severe than others), it is not catastrophic. Already the Defence Department has called back their workers. They represent almost half of the furloughed 800,000 workers.  Upwards of 1.3 million workers are continuing to work but may or may not be paid. Economists estimate that the “shutdown” could cost 0.1-0.2% off the 4^th quarter GDP growth for every week the “shutdown” continues.

The potential looming disaster comes next week. At least that is how many phrase the looming debt-ceiling crisis that could lead to a “default”. The Treasury Department report said “a default would be unprecedented and has the potential to be catastrophic”. The US Treasury Department has even suggested that a US default would dwarf the Lehman Brothers collapse of 2008. The Treasury Department went on to say that “credit markets could freeze, the value of the dollar could plummet, US interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse”. No wonder the Economist’s headline and lead story this week (October 5^th – 11^th) said it was “No way to run a country”.

The warnings do not stop with the US Treasury Department. IMF managing director Christine Lagarde has warned that if Congress fails to raise the US debt ceiling that the consequences could be severe not just for the American economy but for the global economy as well. China has said, “the clock is ticking”. China is the US’s largest debtor holding upwards of $1.3 trillion of US Treasuries. Only the roughly $2 trillion held by the Federal Reserve dwarfs the Chinese holdings. Chinese Vice Foreign Minister Zhu Guangyao has told the US to “earnestly take steps to resolve in a timely way the political issues around the debt ceiling and prevent a US default to ensure the safety of Chinese investments in the United States”.

The political issues are what are hampering the US. Their democracy has become according to the Economist dysfunctional. The sides are extremely polarized. A large minority of Republicans want to kill “Obamacare” the legacy program of the Obama administration that would help provide health insurance to the 45-50 million Americans without health care plans. “Obamacare” was passed by both Congress and the Senate and withstood a constitutional challenge to the Supreme Court. The only way it can be repealed is through an election where the Republicans would need to win the Presidency, Congress and the Senate. Otherwise, as the Economist says the US would always be vulnerable to repeal of laws by a minority if they gave into the Republican demands. The Republican leadership goes along with the minority because to break with them would threaten their own political survival.      

In order to prevent a debt default the US may instead have to slash spending drastically. Slashing spending could lead to a severe recession or depression. So just what could be cut if spending were cut drastically? The US takes in roughly $2.7 trillion annually from taxes but spends $3.5 trillion. A quick examination of their budget items reveals that three items alone account for almost 65% of all spending. They are Medicare, Social Security and Defense/Military. Add in three more items – Income Security, Interest on the Debt and Federal Pensions and one has accounted for about 89% of all spending. That leaves only 11% of the budget for pork barrel items and others including Homeland Security. On top of that the US has anywhere from $60 trillion to $200 trillion of unfunded liabilities which includes primarily Social Security, Prescription Drugs and Medicare. No word on how that is to be funded.

It has been noted that the US can take steps to slow down or delay a debt default. Some contend that the US could go to mid-November before the crunch could come and the US is unable to make an interest payment or was unable to pay back maturing securities. This also assumes that all debt issuance comes to a halt as well. There would be no more weekly Treasury bill auctions or regular Treasury note and bond auctions. Many are betting that the US won’t default and that could well be correct. If that were the case then the other likelihood is a drastic cut in spending. Could it be that Grandma won’t get her Social Security cheque? 

It has been said that the President could invoke the 14^th Amendment that states under Section 4 “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void”. (Yes, it was written that long ago – July 1868). However, many believe that the President would not invoke the 14^th Amendment as it could spark a constitutional crisis instead.

The US budget deficit as a ratio to GDP is not a major issue. It currently stands near 4% and it is expected to fall to 3.4% in 2014 and 2.1% in 2015. These are not drastic levels and the trend is downward. Japan currently stands at 8.3% and Great Britain at 7.6%. Canada is at 2.9%. Even Greece is only at 4.7% but for other reasons Greece is considered a basket case. The Euro zone as a whole stands at 3.1%. As well US budget spending as a ratio to GDP is also not that large currently at about 22%. The trend there is also downward. By contrast, Canada is trying to lower its budget spending as a ratio to GDP to 25% by 2015.

What role will the Fed play in this? The Fed has already been instrumental in bailing out the banking system during the 2008 financial crisis. The Fed has carried out QE1, QE2, Operation Twist (OT) and QE3 (some say they are already on QE4). All this supposedly to boost the US economy. Except it is not doing a lot of good. The US banks average loan to deposit ratio has been falling since the 2008 financial crisis. This suggests that the banks are just not lending out money even as they add assets to their balance sheet. It really shows up in the velocity of money (M2) as it has fallen to record lows. Money is just not turning over in the economy.

Credit is the lifeblood of the economy. Credit is just not flowing because the debt situation is still too untenable. Student loans now exceed $1 trillion and are at roughly the same amount outstanding as sub-prime loans were in 2007. Like sub-prime loans much of the student loans have been securitized. It is estimated that at least 20% are uncollectable. It could be higher. That throws the valuation of the securitized student loans into doubt. Mortgage defaults remain high as well. While the mortgage delinquency rate is down from the peaks of 2008-2009, it remains sharply above the lows of 2005-2006. That leaves the securitized mortgage market open to more shocks if confidence should collapse with a US debt default.

Source: www.stlouisfed.org

Instead, the money that Fed has handed the banks has come back to the Fed in the form of bank reserves and/or has gone primarily into the stock market to boost asset values. With the money coming back to the Fed in the form of reserves the US Monetary Base has effectively quadrupled since the 2008 financial crisis. So has the Fed balance sheet. But the US stock market has also gone up retracing all of the losses from the 2008 financial crisis and then some.

If the Fed were to pull back on QE (the “taper”), the US stock market would fall and interest rates would rise. Ever since there has been talk of the “taper” the stock markets have wavered, interest rates did go up and gold fell sharply. Could the Fed bail out the government just as it did the banks? Well that is possible. If banks are too big fail then the US government is also too big to fail. Besides TARP, it is estimated that anywhere from $8 trillion to $16 trillion was loaned out by the Fed to help stabilize the financial system during the 2008 financial crisis. If that kind of money could be lent during a banking crisis, it could also be done to prop up the US in the event of a potential default.

The markets, however, are reacting nervously. That should be no surprise. Not even gold is responding to the looming crisis. The stock markets are rolling over, gold was trying to rise but has since pulled back and interest rates that were rising appear be to be trying to fall again.

The weekly charts of the S&P 500, gold and the CBOE Ten Year Treasury note are presented below. The MACD indicator may be the best clue as to future direction of all of them. For the S&P 500 it is rolling over and has been for months even as the S&P 500 climbed higher. The S&P 500 has had three thrusts to new highs and the MACD indicator made lower highs each time. The MACD is now pointed down. The S&P 500 appears to have significant support down at 1,600 and that may be the extent of a short-term objective. A break under that level could signal a more dangerous bear market getting underway. The next major level of support does not appear until around 1,350.

 

Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

Gold fell sharply once it broke through $1,525 last April. The collapse was triggered by an unusual offering of 400 tonnes of paper gold (futures) all at once in the early morning trade of April 12, 2013. The offer panicked the market. The market found a bottom in late June 2013 hitting a trend line coming down from lows seen in 2011. Since then the market has turned up but now appears to be moving down to test the June lows. It is not unusual to make a test of the lows or even see slight new lows. During the 2008 financial crisis the markets plunged in September bottomed in October then rallied before falling again making slight new lows in March 2009.

The MACD for gold has turned up and thus far the pullback has failed to pull the MACD down again. New lows for gold could be seen but as long as the MACD holds up then odds would favour that a final was in. The bottom of the channel is currently near $1,150. That appears to be the current downside risk.

Just as one would think that gold should be rising in the face of the looming debt ceiling crisis it instead fell. Oddly, the drop came with another seeming well-timed report from Goldman Sachs suggesting that gold should fall. A bearish report from Goldman Sachs came out just before the collapse on April 12, 2013. But Goldman has recently put out bullish reports for gold as well. That may not be unusual as while there does appear to be short-term weakness the longer-term prognosis remains quite positive for gold even from Goldman.

Gold demand remains strong particularly out of China. Given China’s concern over the US debt situation China continues to import gold to add to its reserves. In the first eight months of 2013 China imported 744.8 metric tonnes of gold which was more than double the 361 metric tonnes during the same period of 2012. India, who has been trying to control the importation of gold, is instead seeing a surge to near record levels for silver. Despite controls on the importation of gold into India demand continues to outstrip supply and premiums have reached as high as $50 an ounce over the spot price of gold. The bearish reports out of Goldman and some others appear to be at odds with ongoing strong demand for physical bullion particularly in Asia.  Could there be a correlation between bearish reports from Goldman and some others to quick drops in gold prices (futures) during hours when market trading is thin?

Gold has a lot of work to do but the fundamentals remain sound. Gold’s fundamentals are so sound that the US Treasury has stated that they would not sell any of the US’s gold reserves in order to pay the bills if the budget crisis were to escalate. Besides, at today’s prices the US’s gold of roughly 8,100 metric tonnes would only fetch about $340 billion barely a month’s expenditures.

If the US announced it was selling its gold it would most likely spark a panic. Other central banks notably Italy have also stated that they would not be selling their gold to cover debts. According to the central banks, it is all about maintaining confidence. Central banks notably in Europe did sell some of their gold in the past. Much of it was sold at or near the bottom of the market in the late 1990’s. The debt-ceiling crisis could still prove to be a catalyst for gold. Regaining back above $1,350 could be the trigger to higher prices.

Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

 

Interest rates have been rising for several months. The US ten-year Treasury note made its low near 1.44% back in July 2012. On fears of “tapering” by the Fed, the ten-year note rose to 2.98%. It has since pulled back to 2.65%. The ten-year note ran into resistance of a trendline down from highs seen in 2007. In turning down recently, the MACD is trying to cross to the downside. This suggests that interest rates could have further to fall. If that were correct, it would fly in the face of a debt default. However, it is still too early to tell with interest rates and they could just as quickly resume their recent upward trend.

The Fed does not want to see the ten-year interest rate rise above 3%. As the ten-year rate approached 3% in September the Fed announced at the FOMC that there would be no “taper”. The Fed has made it clear that they would not be hiking interest rates any time soon. The dates for interest rates to rise keep getting pushed out further. The appointment of Janet Yellen as the new Fed Chair is not about to change the dovish approach to interest rates that has been in place since the 2008 financial crisis. Some believe that she could provide even more QE.

As noted earlier the US cannot afford a hike in interest rates. Low interest rates are most likely here to stay for an undetermined period. Japan has held interest rates low for over twenty years in an attempt to revive their moribund economy. Low interest rates are causing all sorts of dislocations in the economy. Pension funds in North America and Europe are generally quite underfunded. Low interest rates are not helping.

Looming in the background is the potential for pension funds to be nationalized. That does not mean that the pension funds are seized. Instead the cash strapped governments use the pension funds to place their debt. This has already happened in Poland. Cash strapped governments in Europe and North America can no longer afford to bailout the banking system using taxpayers funds if another financial crisis were to hit. Instead, laws have been passed in North America and Europe to authorize bail-ins. This puts anyone with funds in banking institutions at risk. This was the model used in Cyprus. Cash strapped cities are also at risk as Detroit has discovered. There is little help coming to save Detroit from bankruptcy leaving the pension funds and workers at high risk of losing benefits and their jobs. Numerous other US cities have already declared bankruptcy or are on the verge of bankruptcy.

The headline “Houston we (may) have a problem” may be correct given a holding firm President and an intractable Congress locked in a possible death spiral. However, many expect that a deal will be cobbled together or that a solution could be found by going around Congress. There is simply too much to lose.

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Copyright 2013 All Rights Reserved David Chapman

[email protected]

[email protected]

www.davidchapman.com