S&P Under Attack from the Government

I had made a prediction last year, found HERE, that US Treasuries would be put on negative watch by Fitch and downgraded to junk by China. Well, I was wrong as it was S&P who made the call and actually did downgrade the US to AA+ which is still a joke as the government will never be able to actually repay much of the $14T it has outstanding without just printing money, which IS a form of default. China is now saber rattling about the US dollar again, but this time they are serious, I think at least, asking for a new reserve currency and I think they will get what they want as other countries have raised the same concerns.

The US deserved to be downgraded and we should be downgraded much further than AA+ as we will not get serious about debt reduction. To prove my point all we have to do is look at how the debate is structured. The politicians are all talking about annual deficits and NOT the outstanding debt load. They do all sorts of double talk to make sure the average person only believes we have a trillion or o in outstanding debt, but that trillion is just the annual deficit and no one talks about the big number of $14T in outstanding current liabilities. S&P gets it and that is why they are the first one to downgrade the US.

When the downgrade happened the Treasury Department acted quickly calling the move unjustified, political, terrible lapse of judgment, S&P made a mistake, and these are the same people who rated junk bonds AAA to begin with. While it is easy to criticize S&P for their prior actions, but relative to its sovereign debt ratings those arguments hold no water and anyone with a stitch of unbiased rationale realizes that the US is indeed in big trouble and we do not deserve a AAA rating. The worst part about this downgrade is the fact that the government is now baring down on S&P about this downgrade.

It was just announced that the Senate Banking Committee will be looking into the downgrade. While we do not know if hearings will happen or not the person close to the matter did say all options are on the table. I was under the impression that Congress wanted independent ratings agencies along with an independent Federal Reserve. Silly me I guess as the minute a ratings agency does the right thing they try to crush it with Senate investigations, but the Federal Reserve can monetize trillions in US debt without Congress blinking an eye, unreal.

What Congress is saying is be independent as long as you do what we say and want and if you decide to think for yourself, well, we will hunt you down and skin you alive. The government is acting very much like the old Soviet Union and is sending a message, not matter what we do keep us rated AAA. How can a ratings agency offer an independent review of a security if the government demands that it gets what it wants regardless of what the facts are? It is insane to think that the ratings agencies will remain independent if Congress has investigations if the US is downgraded. Frankly, this is extortion, blackmail or a combination of the two since the government is the one who issues S&P with its ratings license. Will S&P lose its license over this? I do not know, but it is possible and shameful if that is what happens.

As an American you should be angry over the downgrade, but not at S&P. You should be angry at the people who rubberstamps every bill that comes along wasting billions of dollars. You should be angry at their inability to work with each other and address the seriously obvious structural issues that will consume immense amounts of capital in the coming years. You should be angry that the Senate wants to investigate S&P while saying other quasi government agencies are left alone even though they are part of the problem. You should be angry that Alan Greenspan, Mishkin, Bernanke and every other clown out there says the US will never default because we can print our own money to pay the debt, devaluation IS a default.

You should NOT be mad at S&P and you should demand that Congress work on real problems because their lack of dealing with those problems is exactly why S&P downgraded them to begin with. We are not showing the world that we are capable of fixing any real problems. What we are showing the world is that if we do not get our way we will simply create problems were none exists and threaten the “trouble maker” with depriving them of their livelihood or by throwing them in jail. Way to go America.

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It is June and the economy is weakening

I suppose it was back in the late fall and reiterated again in mid-winter that I believed the market would simply go up for no real reason until QE2 ended

Where are we?

It has been almost 3 years since the collapse of the banking sector and the governments of the world have spent trillions to not only save the banks, but to stimulate the economy as well. We have been told for the better part of 2 years that we are recovering, and we are to a certain extent, but the headlines remain exactly the same over the last few years. They say something similar to: the recovery is on the way, is the recovery in jeopardy, the recovery is in full swing and so forth. Well, we are either recovering or we are not and it is difficult to believe the news when the headlines and underlying story remains the same, a weak recovery.

I view the economic data as severely mixed 3 years into this thing that we are in. Some data is good, but it is largely inconsistent with one month being great and the next being so-so. What has remained constant is the employment situation which is a leading indicator for this recovery. The labor markets stink, to be blunt, and we have only a few good reports to talk about. Unfortunately even those good reports are not enough and do not even keep up with the population growth. We need some 350K jobs created every month to see a real impact on the employment situation. It is clear that we are far away from a number above 300K in the employment report given that we are still seeing initial claims coming in above 400K a week, a few sub-400K claims reports are not encouraging given we are 3 years along and in a “recovery” mode in the economy.

I fear that many companies have learned that you can grow a business with less people. This is apparent with many firms having stellar earnings along with sky high profit margins. If a company can make more or the same with less overhead they know that there is no point in hiring extra bodies until they absolutely have too. That is not good news for the employment situation by anyone’s model and it is unlikely to improve anytime soon.

On top of the unemployment headwind we are now back to $4 a gallon gas. Very few people realize the impact of high gas prices on the cost of living until they go shopping. We are still very much in an oil driven economy and as the cost of oil rises so do the prices on everything from toothpaste to ice cream since some products are made out of oil and all products are shipped by burning oil. This is not news, but it is important to emphasis the importance of energy in our economy since higher prices lead to lower consumption and creates a negative feed loop on everything from jobs to retail sales. Obviously other commodities also play a role and all commodity prices are very high which does not help anything.

So, where are we? I think stagflation is the word we should use. We have a stagnant economy with jobs but rising commodity prices, which is also considered inflation. We are 3 years into this thing and we have been getting beaten over the head with the term “recovery” so much that I believe we have forgotten what a recovery really looks like. I can assure you that this recovery is not normal and for many Americans there is no recovery at all. I remain convinced that we have largely been through a statistical recovery and there has been little improvement in the real, American, economy. Overseas or emerging market economies are booming and largely responsible for US company’s great earnings, but since most of our manufacturing was outsourced this boom is leaving many Americans out in the cold. This also explains why our manufacturing economy, 12% of our GDP, has been doing so well, growth is coming from abroad, not from inside the US economy.

I realize this may not be news for many people but it might be as the permabulls need to understand what is going on. Yes, there is a recovery, but not for most Americans. More importantly this bull market we have is not real. Sure, stocks have done extremely well, but this growth is coming from everywhere else but the US and all the growth is driven by very cheap money. Once external growth slows or the cheap money comes to an end there will be a price to pay when it ends. The question to ask is when will it all end? I do not know, no one knows, but my guess is the tightening in China is a clue that we are much closer to the end than the middle. In fact, even in the US the cheap money may stop in June, unlikely, but possible as QE2 ends.

I had turned bullish a few months ago and stated that once the liquidity from the Fed ends we will have to pay the piper in the form of a correction. I believe that statement to still be true, but I do not believe the Fed will stop its QE programs for very long. Nothing is normal in our economy when we have had the US government spend trillions and the Fed expanded its balance sheet the way it did plus do 2 rounds of QE… that is not normal. But this abnormal behavior saved stocks so keep the bet going until June, but I believe when the VIX is under 18 one should be a buyer and at 15 everyone needs to own the VIX in some way. Since everything remains abnormal be cautious, buy protection through the VIX, buy commodities on the dips and look for dividend yield in stocks.

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M.A.D. makes me mad

Mutual assured destruction, M.A.D., is the term du jour out of Washington and Wall Street over the past 3 or so years. Regardless of who is in charge there seems to be fear mongering for every situation in today’s world. The latest MAD scare is over the debt ceiling and if it is not raised the world will stop and we all will die. I can assure you that none of this is true and the sun will surely rise and set the day after if the debt ceiling is not increased.

I am not saying that by not increasing the debt ceiling everything will be fine, but I am saying it is not as bad as we are all being told. It is insane to believe that the world will shut down if the debt ceiling is not increased and the fear mongering must stop. If the debt ceiling is not raised it simply means that government spending would slow down and be limited to what the Treasury Department collects everyday and no debt can be issued in excess of the designated debt ceiling. However, the debt that matures, since most interest is paid before maturity (I am simplifying this) the debt that has matured can in fact be rolled into longer term bonds. Basically, nothing major would happen right away but in time there may be issues.

What would happen is many federal employees would be fired and many agencies would close. Obviously this is not good news, but it is not horrible news either. The government collects some $200B in taxes or fees a month which means that all our debt servicing costs would be covered in just one month’s tax collection, obviously interest payments are spread out, but you get the idea. Interest rates will not rise out of control and we are not defaulting on our debt, don’t forget the Federal Reserve is our largest creditor and they hand over 95% of their profits to the treasury which reinforces my point since the government is paying interest to itself on over a trillion dollars of our debt.

If the debt ceiling is not raised things will be tough and unemployment, from government employees, will rise but life will go on and much of the private sector will remain untouched. In fact the private sector might just flourish since many regulations could not be enforced because government agencies are closed down. Subsidies would end and waste would be purged from the system, again I see no downside here. The government would be forced to live on what it collects and this clearly bothers the powers that be since they are buying political favor through wasteful spending.

Contrary to popular belief Social Security checks would go out and Medicare payments would still be paid since FICA withholdings cover these costs for now. Well, in theory that is what would happen, but since the government raids those programs excess reserves all the time they are not technically solvent. Even though these programs are safe through their own taxation Washington is telling you the exact opposite which is a lie unless they used those tax withholdings for something else. This is how MAD works though, scare you to death so you don’t question anything and do what you are told.

You see if the debt ceiling is not increased the house of cards begins to waver and that is the problem. The government and the powers that be do not want you to realize that this whole thing is very wobbly and unsound, meaning our economy. They do not want you want you to know that money is debt and the Federal Reserve cannot print money without being paid interest from the treasury department. They do not want you to know that things can get done on less money. They want to scare you into keeping the status quo which is on its last leg anyhow because debt cannot increase forever. Eventually everything comes to an end, look at Greece and Ireland.

Ultimately the debt ceiling will be increased without much of a fight some grandstanding of course, but no real resistance will come and the vote will come and go quietly. What is so crazy is the use of the MAD policy that is used for everything nowadays. No matter what is happening we are told that we are all going to die if so and so bill is not passed which is not true, ever. Why we all fall for this is beyond me, but most Americans do and insist that the wrong decision be made, i.e. preserving the status quo. However, the status quo is unsustainable even in the short-term and is completely evident when one looks at the value of the dollar and the price of commodities.

To be clear on my stance, I know longer term the debt ceiling must be increased as we would eventually default, but I am confident that the US could make it much longer than anyone thinks without issuing new debt. It is just most people who depend on the system for their survival would not like this and that is why the MAD card is being played. We should all be appalled that our leaders are using the MAD card so often and it should be perfectly clear to everyone that when the MAD card is played it is to preserve our leaders and it usually is not in our best interest to continue with their status quo. In time we must start to call our leaders out and see what would really happen if they do not get what they want and I am very sure that MAD will not happen.

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Are we at the end of the line?

I rarely wear my beliefs on my sleeve and I do not mean to start doing so now, but I have been doing a lot of thinking and praying for the people in Japan. The images we are seeing and the reports we are bombarded with are horrifying to say the least. It also proves that we are all interconnected and what happens abroad does indeed impact us here in the US, even earthquakes and tsunamis. I hope that all who read this will take a minute to at least think a few kind thoughts of well being for the people if not outright say a prayer, donations to the Red Cross would not hurt either.

With all that said it is shameful for many of the pundits to hop in the TV and talk about how good this tragedy is for the Japanese economy. It is not a good thing and it will not bring prosperity to anyone let alone to the US. First and foremost, Japan likes to keep its business local so I can assure you Caterpillar will not win out on contracts versus its local competitors. Over and above that this horrible event will create a huge drag on global GDP as the number 3 player is out of the game and who knows how the nuclear situation will turn out. That means Apple should have saved its $200 on its press release announcing its plans on postponing the launch of the iPad 2 in Japan since everyone knew that already and, frankly, who really cares about the iPad launch in Japan when the locals are being exposed to radiation.

With the number 3 player out of the game the economy in the US, China and the world will slow, I am sure of this. It also means QE 3 is a given and the next one will be a fairly sizable easing program. I am so sure about more QE because the Japanese will have to sell treasuries at some point to cover the rebuilding effort. Their central bank have added an astounding 55 trillion Yen, $700B USD, of extra liquidity, but not even the Japanese can print their way out of this thing. They will have to sell and there is no one to pick up the slack for US treasuries right now, to the level of selling that will come. On top of that I believe Japan selling may be the trigger for China to unload some holdings as well, we will see about that. The Fed is the only one around to pick up the slack and give the US Treasury interest free loans, since earnings must be repaid to the treasury department.

Even before this tragedy I was perplexed about the Fed’s QE 2 program. It was not needed, in my opinion, as rates were low already and capital was flowing again. The only reason I could see QE 2 being needed for was to prop up the stock market and by Bernanke’s own admission that is what it did since bond yields have only gone north since the start of the program, the opposite of what Ben wanted to happen. Besides the markets needing a boost the only other reason I could think of for this type of easing program was that the end of the line was here. What I mean is that the Fed may have known that the market was going to want higher interest rates from the US since we have piled on the debt in the last few years.

Basic mathematics tells you that the US cannot handle higher debt servicing costs which is why the treasury rolled out over 50% of our debt to mature in less than 7 years. On top of that every 1% increase in debt servicing costs adds about $120B a year to the budget which is also known as the debt death spiral. However, with QE 2 the Fed can jump in and buy up this higher yielding paper and kick back 95% of the interest back to the treasury department, almost an interest free loan, which explains why the Fed is monetizing, sorry, buying just issued higher yielding paper. This signals to me that the US government may have reached a breaking point in its debt load.

I am not saying the US cannot issue more debt, not at all, what I am saying is people will want higher rates to hold the paper. No one believes that there is no inflation out there and the only time we see any interest is when things really hit the fan like right now. Think back a couple of weeks ago when the Middle East was revolting treasuries sis nothing and the dollar sank. Compare that to now treasuries are going up but only on the short end of the curve and the dollar, what you really should be watching, is not doing well at all. It is very odd because as treasuries rally the dollar should be seeing some decent strength and here we are sitting below 77 on the DXY still.

This all signals trouble to me as we have seen many revolutions combined with a major economy stopped due to a tragedy and the only thing going up is the short end of the treasury curve. The dollar is not the safe haven it once was and I am not sure what is anymore. I believe gold and silver offer a better alternative than the dollar at this point, but there is volatility there as well. At the end of the day though, precious metals are still the place I would rather be as I see no end in sight for easing and I see higher inflation. I believe this is the end of the line and the Fed has no choice but to monetize more debt. The sad thing about all this is that rates will continue to climb anyhow because it is just too risky to loan money to the US government at this stage of the game.

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