Trust Is the Foundation of All Asset Valuation

Jim Grant on Gold

The latest Barron's includes an interview with Jim Grant titled Jim Grant:  Gold Still Looks Good, Japan Doesn't.  Jim's remarks included his opinion of how markets arrive at a price for gold, which appears to be independent of such familiar and tangible things as earnings, dividends, and business prospects:

What I do think is gold is simply the reciprocal of the world's faith in the institution of managed currencies.  It is one divided by T, where T stands for trust.  And trust is a shrinking number and will continue to shrink.  Therefore, I am still bullish on gold.

Jim traces the origins of this relationship directly to the world's central bankers and their extraordinarily easy monetary policies:

If a bubble connotes absurdity, what is absurd are the monetary conditions that supported this gold bull market.  Gold is an expression of the world's justifiable distrust of the way our central bankers conduct their affairs.

I am not sure that I would limit the origins of this inverse relationship to central bankers.  Legislators in numerous countries have made egregious errors over the course of decades in piling up unsustainable levels of public debt, and too many citizens have imprudently acquired unsustainable levels of private debt.   All of these absurdly foolish conditions justify the world's distrust of the way its affairs are conducted.

The Problem with Repression

 Jim admits that his simple "1/Trust" equation is metaphorical: "The poetry of it is that it can't be quantified."  But we get his point, and in citing central bankers as the cause, Jim rightfully draws attention to the possibility that their policies could harm us even more than they have so far:

And the governments of the world are taking under advisement this notion called financial repression -- short-circuiting market mechanisms, capital controls, punitive taxes or intrusive taxes and the like.

Grant is right in warning of financial repression, and it is already here.   Can you invest your money in a safe fixed income instrument that offers a decent rate of interest?  Of course, you can't.  As others have observed, the Fed is sacrificing savers in the interests of Wall Street bankers, and present policy distorts the signals that markets send to investors.  It is no wonder that the world distrusts the monetary authorities.

Central bankers are in a bind, because monetary policies alone are clearly failing to solve the developed world's growth and debt problems.  Given this failure, governments will undoubtedly turn to fiscal and regulatory instruments to address these problems.  As Grant warned, our future may include capital controls, intrusive taxes, and other additional forms of financial repression.

The Future of Repression

This coming week we should see the beginning of Operation Twist, which is intended to distort the shape of the yield curve yet again.  The Fed's repressive intent is obvious:  Push investors farther out the yield curve, away from riskless, short duration assets.   They will happily sacrifice your wealth in order to support asset prices and make it cheaper for the over-indebted to deleverage.

As with the Fed's earlier monetary tricks, Operation Twist seems likely to encourage speculation only temporarily, and the authorities will have more tricks up their sleeves, however repressive those tricks may be.  However much we may hope for more meaningful, structural change, we will not see it because it would undermine the system that supports the elites who control a growing proportion of our nation's wealth.   As Jesse's Crossroads Cafe wrote recently, "the monied interests ...  will burn down society rather than give up their seats at the top of the hill."

The Reciprocal of Trust

For the time being, we see investors flee Europe and park their money in dollars, and in such a situation we see even the price of gold waver in response.  At some point the situation in Europe will stabilize, at least temporarily, and the world's attention can then refocus on the profound and seemingly intractable economic and debt problems of the US, and on the flaws of its managed currency.  Where then will investors place their trust?  Can they doubt that the Fed intends to continue devaluing the dollar?  If gold is the reciprocal of trust in the institution of managed currencies, as Jim Grant asserted, the fundamentals of those currencies argue that the "barbarous relic" should see a continued bull market.

Deterministic Debt

We Have Seen It Coming

We had sufficient warning that another economic downturn was coming.   Economic statistics signaled a slowdown, gurus talked about it, and a burst debt bubble required it.   Now the idea has become more widely accepted, but what can we do about it?

Lockhart Says the Fed Could Purchase Assets

The Fed wouldn't expand QE, would it?  Well, it could, and it looks like the Fed is starting to prepare the country for it.  In a speech the other day, Federal Reserve Bank of Atlanta Dennis Lockhart let the country know that the Fed is ready to act and has the means if the economy stalls.  “If additional actions are required, I can assure you the Federal Reserve is not out of bullets.”  What kind of bullets?  “Expansion of the balance sheet or changes in the composition of the Fed’s asset portfolio are available, in my view."

"Treasonous" QE

Isn't expansion of the Fed's balance sheet what set off a commodity bubble and got the world to worry about the soundness of the dollar?   We know that it is ineffective against debt deflation.

Rick Perry wants us to consider QE as treason.  In the Texas governon's first day on the Iowa campaign, he said that it would be "almost treacherous, or treasonous in my opinion" for Federal Researve Chairman Ben S. Bernanke to "print money" before the 2012 election.  We know that QE can't touch the economy, but it was nice of Rick to disqualify himself as a serious candidate.

The Real Treason

I wonder what Rick thinks about the real treason:  Ronald Reagan's avowed goal to bankrupt the United States, just to make it impossible to finance Social Security and Medicare.  Reduce taxes and forget promises about reducing the size of government.  Sacrifice everything to ideology.  That was the real treason, and Reagan's successors, like Rick, gleefully play their ignorant and hateful part.

Who accumulated the national debt after Reagan got the ball rolling?  Nearly half of the national debt since Reagan was accumulated under the administration of George W. Bush.  Bush's tax cuts for the wealthy, expanded Medicare, Wall Street bailouts, and endless war are the things that finally piled up the debt to dangerous levels, and they absolutely dwarf the debt added by the Obama administration.

The Real Cause of the Problem

The economic problems of the United States -- high debt, lack of competitiveness, unemployment, real estate glut -- all have their genesis in the lies and broken promises of decades of earlier administrations.  Excuses were made to stimulate current consumption and fund pet programs, all at the expense of savings that could have funded investments in the future of the nation.

Will Congress Dare to Help?

More QE seems likely to accomplish nothing for unemployment and the real economy.  What we need instead are structural changes, which we are unlikely to get.   If the economic pain gets bad enough, Congress may finally align itself with the suffering electorate, forget its promises to reduce the deficit, and try some fiscal stimulation.  Unfortunately, real structural change seems beyond Congress's intellectual depth.  Also, expanding the federal budget is likely to bring the world's attention back to the ungovernable US debt load.  Policy makers are in a bind.

A Familiar Historical Pattern

None of this is a surprise.  Debt bubbles (balance sheet recessions) take years to work out, and there are no nice ways out.  Worse, this debt cycle is taking place as the competitive position of the US is declining.  The US is standing still or falling back, as hard-working people around the world continue to climb up the economic ladder and compete on the world stage.  Inflated expectations in the US will continue to be frustrated as the nation pays the price for decades of waste.

A Period of Elevated Risk

It still looks like we face a long "muddling through" period, but the trouble with "muddling through" is that it leaves little room for error.  The political impasse over the federal budget and S&P downgrade woke people up to the dangers of the out-of-control US debt load, and more people are looking for exit strategies now.  They know that there is no guarantee that the disastrous debt trajectory will be corrected. 

More QE will only stoke the fires of speculation.  Macro risks seem elevated now, and it looks like a bumpy ride ahead.  Treasuries and gold are already soaring.  Some people are asking:  "Is gold the only safe haven left?"

Zeno's Way -- Part 3

LIE:  High taxes are hampering businesses in the US, preventing hiring, discouraging new businesses from forming.

TRUTH:  Business taxes in the US are historically low.  Business gets a much better break with taxation now than at many times in the preceding century.  Just see the charts below.  Taxes on business revenues today are low both as a percent of GDP and as a percent of government revenues, compared to the past 60 or 70 years.

Low taxes were supposed to encourage investment in plant and equipment, leading to higher economic growth and more employment.   Did it work?   I don't think that anyone would say that we are having a good period of employment and economic growth right now.

The government certainly isn't getting much of its funding from business taxes today.  Of course, that's part of the problem.  We are experiencing a budget crisis now in part because wealthy business interests have been getting a break.  Business and the US can both afford a balanced budget.

The rest of us aren't getting a break.  It's about time the special business interests paid their share of the burden of government.  They get more than their share of the benefits of government. 

Zeno's Way -- Part 2

LIE:  It is Obama's fault that high unemployment and low growth are still with us.

TRUTH:   This downturn is a secular process caused by unsustainably high debt levels and precipitated by a financial crisis, NOT a standard inventory cycle recession.  It will take YEARS to work this out, and the country has in fact been PERMANENTLY changed.  The good old days will NEVER come back.

Don't expect one President to solve a problem that the Republicans and Democrats both worked DECADES to cause.  Decades of misdirected investments cannot be reversed overnight.  The damage to the country's capital is permanent, and high growth won't come back. 

Other nations are rising, productive technologies are spreading, and the competitive environment has permanently been leveled.  The overwhelming advantage that the US had for a short time after WW II is gone forever.  If America is declining now, it is because short-sighted leaders protected their own interests by playing it safe rather than acting like true leaders.   

Don't blame reality on a political party.  NEITHER party wanted to look at reality.

Zeno's Way -- Part 1

Ever since the Federalists and Anti-Federalists duked it out in 18th century newspapers, political interests have used the press to peddle partisan lies and half-truths to the American people.  Today, political interests on the extreme right continue to spread lies and half-truths in an attempt to influence the debate about the US government's budget deficit.   Right-wing ideologues in the service of elitist special interests have done the country a grave disservice in poisoning the debate with their lies about the budget deficit, lies which many so wrongly believe.  These servants of the radical special interests are, in fact, steering the nation in a direction will do nothing to solve the problems underlying our economic and budgetary problems.  Their proposals will instead bring hardship to millions of Americans.  Today's blog entry is the first of a series to restore a more balanced dialectic by contrasting those lies to the simple truth. 

LIE:  If we get the government's fiscal house back in order, everything will be hunky-dory with the economy in short order.

TRUTH:   Those expecting an immediate comeback in the economy are either totally deluded or vicious liars.  The spending reductions needed to balance the US budget are so large that they cannot fail to cause a severe reduction in the pace of economic growth.  Economic activity can only contract if the government reduces transfer payments to the elderly, the poor, and the disabled.  If the military budget is cut back, there will be immediate reductions in industrial activity and in consumer spending by military personnel, their families, and the civil servants who are let go.

MORE TRUTH:  The economy is not coming back in any recognizable way for years.  We are experiencing a period of debt deflation, not an ordinary inventory cycle.  Private citizens, the financial sector, local and state governments, and the US government are all buried under excessive debt loads.   Excessive debt cannot be worked off in weeks or months in the absence of confiscatory policies that would frighten our creditors and land the nation in an even worse mess. 

     

Strike Scene, Louis Lozowick, 1934.

Hiatus

The lack of new posts on Caliban's Market is only temporary, to allow time for travel, genealogical research, and other activities.  Look for new posts in a few weeks.

The Coming End of Quantitative Easing

For the past few weeks there has been talk in the press that QE II will pause at the end of June, and last week several Federal Reserve Bank Presidents made statements supportive of this view. As we will see below, there is good reason to believe that the government's extraordinary programs of support are coming to an end. We should seriously consider this, because the implications appear to be serious for market liquidity, rate expectations, and the dollar.

Accommodation Is Already Being Removed

Recent Fed pronouncements about ending QE should not be unexpected, because both the Fed and the Treasury have been cutting back for some time on other programs of financial and economic support. In "Crisis Era Props Are Fading Away" the Wall Street Journal last week reported on other support programs that both Treasury and the Federal Reserve have already started to roll back.

The Treasury Department has already announced plans to sell its $142 billion portfolio of federal agency mortgage-backed securities bought at the worst of the crisis. The Federal Reserve moved to the next stage of a plan to drain liquidity from the financial system through reverse repurchase agreements, or "reverse repos." Some of these moves have been going on for months. The Fed started testing reverse repos in the fall of 2009, and it has been some time since the Treasury ended several emergency-lending programs that eased the credit markets through the crisis.

More moves are being contemplated. The Fed is considering an auction for some of the subprime-mortgage securities acquired in the bailout of American International Group Inc.

Reasons for Policy Change at This Time

As pointed out by Glenview Capital in the blog Pragmatic Capitalism, there are some fundamental reasons for QE to pause: (1) the economy has rebounded (at least by some accounts), (2) the risk of immediate deflation has receded, (3) rapidly rising prices of oil, food, and other commodities provide some indication of incipient price inflation, and (4) Fed commentary has grown more cognizant of the risks of inflation.

In addition to the reasons cited in that article, the Fed probably wants to normalize policy so as to leave some "dry powder" ready to counteract the next recession or financial panic. Also, private financial institutions have stabilized to some extent, although much of their problems are being hidden at present by Treasury and Fed programs and by official tolerance of mark-to-fantasy accounting.

Recent Federal Reserve Comments

Based on recent statements, the Fed appears now to be in favor of putting an end of QE, if conditions continue stable or improve. Not long ago, St. Louis Federal Reserve Bank President Bullard said this quite plainly: "If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we're going to start withdrawing our stimulus, and I'd start by pulling up a little bit short on the QE2 program." Then last Friday a parade of Federal Reserve Bank Presidents made well-coordinated statements like these:

Speaking at a conference in Marseilles, Bullard said “The economy is looking pretty good. It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short.”

Speaking at the same conference, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said: "If the economy evolves the way I've forecast, I would not foresee us doing further accommodation." He added that the U.S. economy would need to worsen “materially” for the bank to consider further bond-buying.

Atlanta Fed President Dennis Lockhart said in a speech last Friday that "it's a high bar" for the Fed to pursue more QE. He told reporters after his speech that he favors completing the present round of asset purchases as scheduled but opposes additional moves based on his current economic forecast.

At a speech in New York a speech in New York last Friday, Charles Plosser, President of the Philadelphia Fed, said: "If this forecast is broadly accurate, then monetary policy will have to reverse course in the not-too-distant future and begin to remove the massive amount of accommodation it has supplied to the economy." He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

Charles Evans, President of the Federal Reserve Bank of Chicago, said to reporters at a meeting at the bank that the current program of QE was enough: "Following through on that to the tune of $600 billion, like we've said, I think is appropriate. I personally don't see as many needs for a further amount, as I probably thought last fall."

The rhetoric has continued this week. Richard Fisher, President of the Dallas Fed, said today in an interview on Fox Business that he would vote against any further monetary easing by the central bank after the current program is finished in June. He was definite about this: "I cannot foresee a circumstance where I can support any further liquidity in the economy."

Pressures on the Fed to End QE

A stabilizing economy and a stable financial system have been cited as reasons for taking a pause in QE soon. These are not the only reasons why the Fed might end QE -- or say that it is going to end QE. There are other possible motives that include both real-world finances and Washington politics.

Another reason to consider ending QE in the future, if not right now, is the dollar. The ability of this country to remain solvent depends on maintaining at least some value for the dollar. So far, the dollar has declined only gradually in reaction to the government's extraordinary support for the financial system and the economy, but many of our creditors have complained about the trend. Naturally, dollar weakness is a big issue with the Fed, and they need to do something about it before heretofore modest dollar weakness turns into panic.

Partly, the problem can be seen in the continuing flow of dollars into commodities. When consumers and investors see commodity prices rising suddenly, they try to preserve wealth by exchanging dollars for commodities. This is not what the Fed wants. They want you to hold dollars and other US financial assets, not barrels of oil or gold ingots. A related view is that the Fed needs to forestall the incipient inflation seen in rising commodity prices. In addition, all of this speculation is destabilizing to the markets.

Many observers (such as Bill Gross of PIMCO) worry that the Fed is taking a big risk by tightening policy while it has been buying one-third of all US Treasury issuance. This may be a risk, but others point out that the Fed may already have enough securities on its balance sheet to control rates, and that it doesn't have to depend on incremental purchases.

Maybe the most persuasive explanation for the Fed's recent statements is that it needs to placate the fiscal hawks in Congress. According to this point of view, the Fed is just biding its time until forecasts of robust economic growth are proven wrong. At signs of a faltering economy, the Fed can rein in talk of pursuing QE and start preparing the markets for QE III. Signs of a faltering economy may not be long in coming, considering that the most recent economic data are not uniformly encouraging, and many economic forecasts are being cut back.

Problems with Pausing QE

Unfortunately, a pause in QE would happen at a time when overall economic and financial conditions are hardly conducive to monetary tightening. As Glenview Capital wrote in the blog Pragmatic Capitalism, "a renewed emphasis on deficit reduction in Congress ... will likely slow the growth of both Federal and State/Local spending that has played a key role in reinforcing the economy to prevent a double-dip recession." This austerity-induced fiscal drag seems likely to add its own burden on the weak economy.

If they come to pass, these domestic drags on the economy will happen against a global backdrop of economic negatives. These include high oil prices induced by fears of continuing political unrest in the Middle East, financial instabilities induced by the continuing debt crises on the periphery of the European Union, and the possibility of tightening by China to rein in inflation pressures and rein in an unbalanced and overheated economy.

Pausing QE would tend to raise interest rates, which is a situation that the financial system may not be ready to face. As Bill Gross asked: "Who will buy Treasuries when the Fed doesn't?" This raises the additional question of how high rates might go when the artificial foundation of QE II credit is removed. There is also the question of how well the economy and the financial system can withstand higher rates. The economy hardly seems robust enough to withstand sharply higher borrowing costs. The financial system gives appearances of having stabilized to some extent, but that leaves the question of how dependent is has become on the continuance of rock-bottom interest rates.

There is also a risk that fiscal austerity, induced by fears about government deficits, might actually worsen that situation. This is because the stabilization of the economy has been dependent on stimulus through growth in Federal expenditures. With reductions in Federal, state, and local budgets, there is a higher risk that growth will falter, and that lower economic growth will reduce tax revenues and increase the deficit.

                               Barbara Stevenson, Apple Vendor, 1933-1934.

All of this paints a picture of a financial and economic environment that is hardly appropriate for monetary tightening in the US. As noted above, recent economic news is not encouraging, and continuing signs of weakness could easily raise new fears of another recession.  We have to wonder if QE would not need to be quickly resumed if this uncertain economic climate resumes a downward course.

Tightening to fight inflation runs the risk of undercutting the recovering economy, a situation which would place the Fed and Congress between a rock and a hard place with respect to policy choices. This could lead to a real dilemma for policy, that perhaps deficits cannot be reduced without further weakening the economy.  Perhaps we should not be surprised to see such a dilemma, given that this country has seen decades of Fed policies and national budgets sending false signals to the markets that induced economic participants to misallocate resources into consumption rather than productive investment.

QE and the Markets

One of the best discussions about pausing QE that I have read was John Hussman's March 28 commentary. His argument is based on the fact that "the primary factor behind the market's recent advance has been speculation based on the belief, explicitly encouraged by Bernanke, that the Fed would provide a backstop for risk-taking." The implication for the markets is clear. If the Fed does not enter into another round of QE (and certainly if the Fed unwinds past QE), it risks an "an increase in risk aversion" and "a decline in speculative enthusiasm."

Given the momentum-like behavior of the markets, Hussman believes that investors have not priced in "the extent to which this [the market advance] has been reliant on various stimulus measures that are now drawing to a close." In fact, low market returns were almost guaranteed by the nature of QE. This is because by "increasing the stock of non-interest bearing money in the economy toward $2.4 trillion, all of which has to be held by somebody, the Fed has created a market environment that has raised the prices and lowered the returns on all competing assets." [My emphasis]

There is no way of knowing where the market will go in the short-term, but poor long-term returns are indicated by present market valuations. This is borne out by Hussman's quantitative models, which are definitely long-term and fundamental in their valuation approach. These models assume that "long-term growth in GDP and earnings will persist at the same roughly 6.3% peak-to-peak growth rate across economic cycles," which is the average rate observed over nearly the past century. Based on the level of stock valuations to normalized earnings, "our present 10-year total return estimate for the S&P 500 is only about 3.4% annually," and "the historical skew to these returns easily includes zero in the confidence interval."

Bill Gross's has warned that the end of QE will mean the end of the bull market in bonds and, as we discussed above, there is good reason to worry that the removal of extraordinary monetary accommodation may also drive down the prices riskier asset classes, like stocks and commodities. Whether we agree with all of these arguments or not, it is always a good time to review the asset allocations in our portfolios.

Not Yet the End of the Bull Market in Bonds

PIMCO Total Return Eliminates Government Bonds

A couple of weeks ago there was considerable angst in the press over the announcement that the PIMCO Total Return Fund had totally eliminated its exposure to US government bonds during the month of January. Total Return raised its cash position by a corresponding amount.

In an interview on Yahoo Tech Ticker, PIMCO guru Bill Gross advised investors to stay clear of “bonds in dollar denominated terms” and to be “wary of higher interest rates going forward.” Bloomberg reported: "Gross believes that interest rates on U.S. Treasuries are way too low right now and that they will start going up when the Federal Reserve ends the current round of quantitative easing in June."

Should We Be Worried?

Well, if you believe that rates will rise precipitously when QE II ends, I don't blame you for selling bonds and going to cash. You might even believe, as Zero Hedge wrote, that the "cost of capital could go up by at least 150bps while input costs are rising, margins are compressing and liquidity drying up." In that situation, it might even make sense to "get the hell out of Dodge in all asset classes."

But is there reason to be so greatly worried about rising rates, especially at the end of QE II in June? I certainly agree that the US faces persistent, multi-year problems with interest rates and the dollar. However, it isn't exactly clear that we should have a particularly elevated level of worry about the purported forthcoming event "when the Federal Reserve ends the current round of quantitative easing in June," as Gross says we should. There are differing opinions about the market impact that the end of QE II may have, if it does end then, and we might profit by at least listening to some other opinions.

What Happened to Bond Yields the Last Time?

Cullen Roche, the author of the blog Pragmatic Capitalism, looked at Gross's track record and concluded: "I am not sure there is much, if anything, that we can read into this move by Mr. Gross. He has been talking about some form of bear market in bonds for over 10 years now." For example, ten years ago Gross wrote in 2001 "We are at the end of the secular bull market in bonds," which hardly turned out to be the case then.

Roche also pointed out that Federal Reserve history is against Gross's pronouncement that QE II will lead to a rise in bond rates. When QE I ended last year, and the Fed contracted its balance sheet, interest rates did the opposite of what Gross expected, that is, they dropped.

Of course, the Fed's move was advertised in advance, and bond yields did rise during much of the lead-up to the event.  Also, the context is different this time. There is more public awareness now of the risks of a declining dollar, and attention to the growing US government debt has also increased in the past year. Perhaps it is best to admit that argument from a single anecdote is impossible, and not dismiss Gross's worries simply on that basis.

What Else Happened Last Time?

If we want to use historical analogies, the only time that the Fed previously cut back on a program of quantitative easing was last year. Interest rates fell after that cutback, but what else happened? A full examination of the historical record shouldn't be restricted to a single dimension, bond yields, even if that is the issue that Bill Gross focused on.

In John Maldin's latest column, he quoted from a list that was originally published by David Rosenberg. To quote those two, during the period from late April to late August last year, when the Fed contracted its balance sheet by 12 percent, the markets saw asset price changes that included the following:

The S&P 500 sagged from 1,217 to 1,064….

The S&P 600 small caps fell from 394 to 330….

Baa spreads widened +56bps from 237bps to 296bps…

CRB futures dropped from 279 to 267….

Oil went from $84.30 a barrel to $75.20….

The VIX index jumped from 16.6 to 24.5….

The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5….

The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…

Among commodities, the exception to the overall decline was gold which "acted as a refuge at a time of intensifying economic and financial uncertainty" by rising to $1,235 an ounce from $1,140.

If the end of QE II follows the same pattern as the end of QE I, perhaps there is reason to worry about the short-term impact, because there were price drops across a wide range of asset classes. But the price declines last time did not include the one that Gross identified, namely a drop in bond prices.

The Difficulty of Interpreting History and Statistics

In his Yahoo Tech Ticker interview, Gross said that America's debt level is nearing a breaking point after years of reckless spending, and that we can no longer depend on foreigners for funding. A critical question, of course, is when the breaking point will arrive. Gross cited the work of Ken Rogoff and Carmen Reinhart in This Time Is Different when he said: “When a country reaches a certain debt level, confidence in that country’s ability to repay that debt becomes jeopardized.”

Now, we must be careful here, because timing is everything in investing. Certainly, high national debt levels can be dangerous, but has the US reached a critical level of debt?  Do we expect the US to experience a major bond market dislocation this year, as Gross seems to imply?

The really big problem with Gross's appeal to Rogoff and Reinhart is of course that, when he refers to "a certain debt level," he is referring to average results over a sample of national experiences. Referring a a sample average is misleading. The outstanding aspect of the data used by Rogoff and Reinhart is the variability in the experiences of different nations with respect to the conditions under which they had difficulties paying their debts. There is no way of saying that a nation will default when it reaches a given level of debt, however one defines the debt.

Also, it is myopic to focus attention on only a single variable, the nation's level of debt (presumably as a fraction of gross economic product). Other factors are also critical in determining a nation's ability to pay its debts, including its level of economic activity, prospects for growth, currency convertibility, trade relationships with creditors, and many others. There are good reasons that US creditors are willing to tolerate present debt levels and that the US currently experiences interest rates that are low to moderate in historical terms over the maturity span of the yield curve.

In fact, predicting a nation's ability to repay its debt is not a matter than anyone can achieve with any certainty. Is there risk to the US dollar? You bet. Could the dollar fall more this year? Sure. But will American's ability to repay its debt suddenly end this year? There are risks, but QE II does not seem especially likely to be the trigger for a massive event.

Years, Not Months

Setting a time for a bond blowup is impossible, but the real problem is probably more likely to lie sometime in the next decade, not over the next few months. That is because the big problem is the current high level of US government debt and the likely future growth of that debt, seemingly without limit. Current budgets are heavily in deficit, and entitlement programs —Social Security, Medicare and Medicaid—are set to add ever-increasing burdens that will throw the budget even more into the red. Given the reluctance of politicians to raise taxes to pay for these programs, or to cut entitlements, the national debt seems fixed on a doomsday trajectory that will grow without bound until disaster strikes.

A chart at The Economist is a good place to see the proportion of GDP spent on entitlements and interest, compared with the proportion of GDP that the government is expected to raise in the form of revenues. The data come from the Congressional Budget Office's "alternative fiscal scenario", which is based on today's underlying fiscal policy but also incorporates some widely expected changes, such as an increase in the threshold for the alternative minimum tax rate.  The expansion of entitlements to take up an ever-expanding proportion of the US budget is very striking.

The Economist pointed out that, according to this graph, entitlements and interest will absorb all government spending by 2025. Of course, a crisis will arise well before we reach that point. Not only will there be resistance to letting entitlements crowd other government programs, but the government budget will expand well before that time to comprise an unacceptably large percentage of our GDP. Other economic activity would be crowded out, but markets are certain to react well before that point to demand higher interest rates and pernicious currency exchange rates from the US. As confidence is lost in the US, the point will be reached where the economy falls into depression and the national debt cannot be serviced.

Clearly, the government debt situation poses a very big risk for bonds, interest rates, and the dollar.  In this respect Gross and PIMCO seem perfectly on track in their warnings, although that still leaves the question of timing.

When will the crisis be seen in the markets? Hard to tell, but it seems more likely that the real trouble will be a few years off, say, in the latter half of this decade, rather than at the end of QE II, if it ends this summer. Of course, there are many uncertainties. Determined political action could lead to meaningful cutbacks in government spending, or unexpected economic growth could bring greater tax revenues to the government to reduce annual deficits. Whether a crisis occurs or not, half a decade seems a more plausible period of uncertainty for an American interest rate crisis than does a restricted period like the few months attending the end of QE II, whenever that event actually comes.

Bill Gross's Argument

Gross's stated position on QE II is much more alarmist than the aforementioned historical interpretations would seem to support. He reminded readers in his March letter that the Fed is currently buying about 70 percent of all new US government debt, and he then asked: "Who will buy Treasuries when the Fed doesn't?"

There is no argument with Gross's recognition that "Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets." Without this "handoff and stability" the private sector may indeed be unable to issue debt at the low yields and narrow credit spreads seen in the markets at present.  It is difficult to disagree that this point.

As for the magnitude of the problem that the financial markets might experience if QE ends, we have Gross's estimate" that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%." Of course, in order to be really worried that QE II will end soon, you have to accept Gross's estimate of expected nominal GDP growth. Not everyone would agree that the economic prospect is so rosy.

Perhaps the biggest problem with Gross's alarm is that it posits an event that may not occur. Given the weakness of the economy and the reluctance of Congress engage in fiscal stimulation, it would seem more likely that the Fed will find it necessary to continue a policy of extraordinary monetary easing, rather than discontinue it. Current optimism about the economy seems overdone, and the Fed probably knows that.

There is no denying the existence of near-term risks, but the question is the magnitude of the risk and how it will evolve over time.  Based on this analysis, risks to the dollar and Treasuries should rise as deficit difficulties increase over time.  This isn't exactly the message of Gross's comments, but at least he has stated his arguments publicly, so that we can judge the extent to which we would like to share them.

The Down Staircase

The Stairway to Poverty

Several times I’ve said in this blog that I don’t expect the imminent collapse of the dollar. This isn’t because I’m blind to the dollar’s fatal flaws, but because of the time required for the unfolding of this nation’s budgetary and economic problems, and because the dollar is only one of a number of troubled currencies of declining developed nations.

But I don’t want to give the impression that the dollar is safe. We know that the dollar is on an unsustainable trajectory, and its decline seems inevitable. It’s just that the path isn’t necessarily straight down, and the timing of the dollar’s decline is highly uncertain.

The Dollar Cascade

There is no doubt that the direction is down. Even Chairman Bernanke has said that the US needs to reduce debt, and that the process of deleveraging will involve high rates of bankruptcy and unemployment. In such a spare environment, low rates of economic growth will force governments and individual citizens to adjust their expectations and economic activities downward. Because governments and citizens do not willingly adjust their expectations to reduced circumstances, we cannot expect the process to be a smooth one.

Until the financial crisis hit, the risk of financial collapse because of rising levels of private and public debt was met with official denial. When collapse became imminent, the official response was a bailout of key financial players, a policy of rock-bottom interest rates, and quantitative easing – all temporary measures that left the underlying issues untouched. Private debt was partially transformed into public debt, but the debt remained. The system was stabilized temporarily, but this was only the first step in a multi-year process of deleveraging and economic adjustment.

For these reasons, I see the continuing decline of the dollar as a sequence of stair steps. After falling down a step, the US finds ways to arrest its decline partially and sustain itself at a lower level for a few years. Eventually, the pressure on the US (declining economic competitiveness, value of the dollar, political influence) builds up to a point that resistance gives way and we fall down another step. Over a period of decades, some of the steps may be small and others large and catastrophic. However long we may loiter on any single step, the direction is down.

Printing Money Is Not the Answer, It Is a Symptom

There is a school of thought, based on Modern Monetary Theory, that the US cannot become insolvent. The thesis is that the Fed is not monetizing the debt, and a truly sovereign currency can not be debased into hyperinflation. This position posits that the government does not print money, but rather pushes buttons to create amounts in bank accounts or remove amounts from bank accounts. The blog Pragmatic Capitalism has published a number of articles supporting this position, which might be summarized as: “a sovereign government with monopoly supply of currency in a floating exchange rate system has no solvency issue.”

In my opinion the main problem with discussions of this point of view is that they discuss the wrong problem.  The real issues are this country's ballooning federal debt and its persistent negative balance of payments.  Those are the main forces driving this country to penury, not monetary policy. 

Easy monetary policy, however, exacerbates the problem because it distorts market prices, resulting is the allocation of resources into speculation rather than productive activities.  Nevertheless, I was still interested to read a critique of modern monetary theory in a recent series of articles in another blog that I enjoy, Jesse’s Crossroads Café (Jesse Part 1, Jesse Part 2, Jesse Part 3).  To quote Jesse, the critique might be summarized as “I can print money, therefore I can never go broke.”

A government with a monopoly supply of currency may remain solvent in the limited sense that it can pay its debts in its own currency, but that is such a myopic issue as to be meaningless. What is that currency worth in real terms? Not much, if that government’s debts expand without limit. If debt grows uncontrollably, no sovereign government can escape the consequences.

Theoretical solvency is a false issue if your currency declines against all others, and if everyone understands that the trend is going to continue indefinitely.

If debt grows uncontrollably, relative to the size of an economy, citizens and creditors will notice. What exchange rates will foreign trading partners demand, what interest rates will foreign creditors demand, and what rate of price inflation will domestic consumers experience? As Jesse put it:  “The limit of the Fed's and Treasury's ability to create money is the value and acceptance of the dollar and the bond in market transactions.”

And at some point, after exchange rates, interest rates, and price inflation have escalated to the point that the people are mostly in penury, who will accept that currency in exchange for any service or real good?  At that point such a government really does become insolvent.

The Runaway Fiscal Trajectory

The US and other advanced nations seem unlikely to take significant steps to bring their houses into fiscal order until catastrophe is staring them in the face, and by that time it will be too late. It may already be too late. Even holding social entitlements (such as Social Security and Medicare) at current levels (as a percent of GDP) may be insufficient, according to a study by the Bank of International Settlements.

Both monetary and fiscal policy now appear to be impotent, and there is an increasing risk that government policies may be unable to avoid financial collapse. As Charles Hughes Smith recently wrote in “Beyond the False Dawn: Global Crisis 2020-2022” in his blog Of Two Minds, the policy of easy money is a trap, because we cannot reverse it without catastrophe: “… the status quo is now addicted to unlimited flows of free money. If the flow continues, then inflation will destabilize it; if it's cut off, then rising interest payments will destabilize it.”

Although I mentioned inflation as a problem, this does not mean that every step forward will be inflationary.  Government budget cuts, recession, and falling real income are among the strong deflationary forces that lie in our future at some point.  Different steps on the down stairway will bring different conditions, whether  inflationary and deflationary, whether in the price sense or the monetary sense.  The overall direction is toward economic decline and monetary devaluation, however.

Despite political rhetoric, US fiscal policy is still on a runaway trajectory. Recently The Economist reported in its Daily Chart feature, "I O USA" that neither the Republicans or the Democrats are serious about the deficit:

“Both sides talk about cutting the deficit but are unwilling to risk losing voters by trimming the big budget items: pensions, Medicare, Medicaid and defence. Republicans, who were initially pushed to talk tough on cutting spending by the Tea Partiers, have backed away from what plans they had to take on entitlements since gaining control of the House.”

Stumbling Down the Stairs

At some point people will not accept dollars without a suitable discount, or else they will not accept them at all. I agree with those who argue that the dollar is already unstable and that the present conditions supporting the dollar are unlikely to continue forever. As Jesse stated: “the question is when markets will start putting pressure on governments, not if.”

Apparently, people are catching on to this idea. Mohammed El Erian recently commented ominously about the failure of the dollar to rise in reaction to the crisis in Egypt, Libya, Bahrain, and other countries in the Middle East (my emphasis):

"It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S., worrying about the level of debt and what they're hearing about states and municipalities. I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past."

It does not matter whether the US dollar is or is not the world's reserve currency, as long as the world has confidence in the dollar.  Losing the dollar's status as the reserve currency does matter, however, because it signals that the world has recognized lost confidence in the US.  It signals that our underlying problems of debt and lack of competitiveness have become unmanageable.

As recognition of the fiscal and economic problems of the US become widely accepted, there will be little to restrain the fall of our currency. The debt has been accumulated, the industrial system has been eroded, and government policies are not being meaningfully directed to remedy the fundamental problems underlying the crisis. This mantra quoted from Jesse’s Crossroads Café is an insightful comment on the need for new solutions:

“Both austerity and stimulus will falter in the mire of imbalanced, broken systems and corruption. The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery.”

The Old Always

The thing that hath been, it is that which shall be; and that which is done is that which shall be done; and there is no new thing under the sun.

Ecclesiastes 1:9

Last month, James Montier of GMO wrote a piece, In Defense of the “Old Always", questioning the concept of the "new normal" and what it means for the way we invest these days.  Perhaps not surprisingly for a value investor, his conclusion was that there is nothing new under the sun and that "old always" value investing principles still apply.  I especially liked his observation that the value investing concept of mean reversion still applies, contrary to what some "new normal" proponents have proposed.

What Is the "New Normal"?

Discussing the "new normal" is complicated by the variety of meanings that different writers have attached to the term.  Perhaps the most common interpretation is that the "new normal" refers to the current period of low economic growth in the developed world and the likelihood that this period will continue for years. This interpretation makes a lot of sense, because low growth seems likely to be with us for years, thanks to the unsustainably high levels of debt in the private and public spheres. Indeed, the growing convergence of the developed and developing worlds makes it unlikely that the "old normal" economic proposition will return.

Is the "New Normal" in Investing Returns?

To other observers the "new normal" refers to a shift in investing returns from a distribution with thin tails and more likely outcomes close to the middle to a more uniform distribution with fat tails, or more frequent extreme outcomes.  Bill Gross of PIMCO offered this interpretation in one of his monthly commentaries last year. 

I find this "fat tail" interpretation very hard to give credibility to, because the world has experienced high variance outcomes in the financial markets historically and with a frequency that is much higher than has generally been appreciated.  Bubbles, bankruptcies, and the ruin of old regimes have been fairly frequent companions of financial markets for centuries.  With samples taken over long enough periods of time or across enough kinds of  markets, financial returns have always looked non-normal with fat tails.

                              Joan Miro, Red Sun

Is the "New Normal" in Mean Reversion?

Another PIMCO manager, Richard Clarida, went even further and attacked the very basis of value investing, which is that one buys when a thing is cheap and sells when it is dear.  Clarida wrote, “Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.” 

Come on now, who could really believe that mean reversion is dead?  Not only does this statement ignore the historical fact that extreme outcomes are not that rare, but it also makes the logical mistake of saying that high variance is inconsistent with the mean reversion.  When markets go to extremes, they eventually revert to the mean and beyond, and patient value investors will profit if they wait for the bubble to burst.  This increases the chances for profit when reversion occurs.

Mean Reversion Is Alive and Well

I have to agree with Montier when he says "the concept of the new normal confuses the distribution of economic outcomes (and forecasts thereof) with the distribution of asset markets ... From the perspective of mean reversion, fat tails help to create some of the best opportunities."  Montier's letter also included a chart that illustrates his point very graphically.

History is littered with the remains of proclaimed, but unfulfilled, new eras. Exhibit 6 shows the long-run history for the Graham and Dodd P/E for the U.S. market. Over this time, we have witnessed some quite remarkable, and quite appalling, things – the deaths of empires, the births of nations, waves of globalization, periods of deregulation, periods of re-regulation, World Wars, revolutions, plagues, and huge technological and medical advances – and yet one thing has remained true throughout history: none of these events mattered from the perspective of value!

No One Says That It Is Going to Be Easy

None of this means that it is EASY to apply value principles to mean reversion.  No one can predict the future, which means that no one knows when the top or the bottom will occur. You have to understand the investing  world, and you need to apply valuation metrics, but is this possible today?  Zero Hedge suggested that the metrics have changed:

Yet in a universe in which true asset fair value can no longer be derived, and all valuations are wrapped in the enigma of trillions of monetary and fiscal stimuli, whose stripping is virtually impossible in a world in which everything is centrally planned, we just may have entered... the non-"old always" zone. 

I agree that it isn't easy to apply familiar valuation metrics when the Fed has flooded the market with liquidity, but I don't think that it is impossible.  You just have to adjust your metrics so that they reflect the determining forces at work in a debt-laden world.  If the government assumes private debt to attain financial stability, you need to attend to the political risks as well as the industry fundamentals.  But mainly you need patience.  I'll let Montier answer in his own words. 

It is also worth noting that in order for mean-reversion-based strategies to work, it is not required that the mean be realized for long periods of time, but that markets continue to behave as they always have, swinging pendulumlike between the depths of despair and irrational exuberance, or, from risk-on to risk-off. As long as markets display such bipolar disorder and switch from periods of mania to periods of depression, then mean reversion should continue to merit worth as an investment strategy.