August 2, 2013
By Steve Blumenthal
Like the Wile E. Coyote, we have raced ahead and are finding ourselves out over the cliff. Slower growth, manipulated GDP, underfunded pensions and unprecedented global currency manipulation…we are far from normal conditions – too much debt remains the major global issue.
This week, I discuss three relevant topics:
- Detroit – Bloomberg’s Tom Keene interviews Meredith Whitney
- Bernanke’s 10-Year Treasury Forecast
- Public Debt and Entitlements are Growing at a Frightful Pace
Detroit – Bloomberg’s Tom Keene interviews Meredith Whitney (12 minutes)
http://www.clipsyndicate.com/video/playlist/1778/4165117?title=bloomberg
Bernanke’s 10-Year Treasury Forecast
In March, Bernanke gave a speech about the fundamental drivers for the 10-year Treasury yield and presented this chart about the expected rise in the yield:
The rise in interest rates, as projected by the Fed, looks to be smooth and steady to the upside. Unfortunately, markets don’t work that way as we witnessed in late May into June a 1% move in interest rates from 1.6% to 2.6% (10-year Treasury). Rates run the risk of getting to 4% or 5% sooner and faster than the chart projects. The government can’t afford such a move and the leveraged banks and trillions in structured products will find themselves in crisis.
Public Debt and Entitlements are Growing at a Frightful Pace
Government debt is growing at a frightful pace. The Federal Reserve has monetized 103.4% of net new U.S. Treasury Debt issuance in 2013. Source: Shadowstats.com. In English, the government is issuing bonds to cover its spending needs that are not fully covered by incoming tax revenue. Borrow and spend: the Fed is printing new currency units, buying newly issued government bonds and the government is using the money they borrow to keep themselves afloat. This game can only go on for so long before someone jerks our chain. We have reached a critical point.
The National Debt is now over 100% of GDP. Add in all the other obligations the government has made and the totaled owed is over 600% of GDP. Chart courtesy of Rob Arnott and PIMCO.
The problem is debt. It is slowing us down. Here are some facts:
- Total U.S. National Debt is $16.8 trillion (more than 100% of GDP)
- Total U.S. unfunded liabilities is $125 trillion (more than 600% of GDP)
- Liability per taxpayer is over $1 million (one household can equal 1 taxpayer)
(source: www.usdebtclock.org)
The math simply can’t work. Some form of default is ahead. At the same time, we have a massive concentration in the bond trade. Large investors will go where the Fed is going (the Fed is buying $85 billion per month in mortgages and Treasurys). Many of those trades are highly leveraged. We saw a quick panic with the “taper” comment. Borrow at zero, leverage it up and make the spread. We are in a game of musical chairs and we all think we can win.
In seven weeks, Bernanke and team doubled the Fed’s balance sheet that took 94 years to create. QE1, QE2, Operation Twist and QE3 at $85 billion per month adds up pretty quickly. The Fed had a $500 billion balance sheet in 2000, which is $4.5 trillion today. Nothing has happened to unwind.
JP Morgan has $75 trillion in notional derivatives outstanding. That is nearly 100 times their balance sheet equity. What happens when interest rates normalize? At some point, much of what was created will need to be unwound.
Today, the markets are being driven by Fed word and liquidity injection. This is not a real market; it is not normal and not healthy. Zero interest rate policy until 2015. By then, it will be six years at zero interest rates. Unprecedented! We have the biggest buyer in the history of the world buying up all of the Treasury paper. Absent is normal market price discovery. There will be consequences.
For now, the Fed can come up with some more tricks, as can Japan, the UK, the EU and China, but like the Wile E. Coyote chasing the Road Runner, the Fed is out over the cliff.
Today, investor sentiment is over-optimistic but the cyclical bull market trend remains in place. I expect some sort of short-term correction in August that works off the bullish sentiment extreme but continues to give upside the benefit of the doubt. Money is flowing into U.S. equities and that trend can continue.
At some point in the not too distant future, there will be a monetary breakdown. My best guess is that the real fireworks happen in 2015. There are many moving parts. Some I know and some I’m sure I don’t know. We are in a highly manipulated unnatural environment.
Investing is about taking risks. Every investment is a risk (bank CDs, money markets, bonds, stocks, real estate, gold and cash under your mattress). It is about how you combine your risks that make you either an investor or a gambler. Concentrate an all-in bet on short Yen? I like the trade but size it smartly. It may not win. Trade short U.S. Treasury bonds? I like it too but it may be early still. I don’t know. It is fun to be right but it takes great conviction and more patience than most might have as the timing is very difficult to predict and never adheres to your schedule. It is why prudent investors allocate to a number of probable and non-correlating risks.
Overall, build a broad portfolio that expands the allocation. Build out your third bucket. I like to call it tactical-alternative-other. Be careful, be more active in your investment allocations, hedge your long-term focused equity exposure, shorten maturities, put inflation hedges in place (they are cheap today), overweight tactical and stay liquid across your portfolio.
We are in interesting times to say the least.
Have a great weekend,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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