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David Kotok: A Few More Words From London
Latest from David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors -- Chris
A Few More Words From London
July 16, 2011
London -- In Friday’s FT, James Mackintosh illustrated a critical difference between Europe and the United States. He noted that the Italian debt auction had an interest rate of 4.93% on 5-year government debt. That was a full percentage point higher than last month. He contrasted the Italian auction with the US auction of $5 billion of 2-week debt at an interest rate of zero. As Mackintosh said, with great politeness, “The fundamentals of the two countries do not justify either the optimism over the US, or the pessimism about Italy.”
This is not about optimism or pessimism. This is about the construction that Mackintosh outlined in his column. In Italy, the European Central Bank cannot directly buy government debt. Therefore it can only support Italy through conduits and only in minimal amounts. The conduits are the same banks in the same banking system that are under “stress” because of stress tests and that are dealing with a mix of sovereign debt in Europe that is highly suspect in terms of its creditworthiness.
In the US, the debt markets have the support of the Federal Reserve. The US gets away with its approach because its central bank has a policy that retains an interest rate at zero. Meanwhile, the Italians do not have the ability to use this approach, because their construction with the European Central Bank has taken away the weapon of maintaining their own sovereign debt in their own currency. In the old days, when the Italians used lira, they too had the ability to directly finance themselves.
The victims of the policy difference are the investors, the bond holders, and all those tied to them. Think about this as trillions of dollars around the world, impacting nearly all the elements of finance and government that we can imagine.
If you contrast the two interest rates, you find some remarkable comparisons, which Mackintosh has summarized in his columns. He writes that "the Italian government should have a surplus before interest" due to its new budget austerity. Meanwhile, the US is expected to run a deficit of 9% of GDP, before interest, this year.
We digress again. Note the difference between Italy responding to the impact of higher interest rates and changing its political mechanism, with political adversaries coming together out of a national interest. Contrast that with the United States and the behavior of the Democrats and the Republicans, which we would rate as poor, impoverished, irresponsible, and foolish. We too are being polite.
If Italy could borrow at US rates, then Mackintosh calculates that Italy “would look [to] have a budget deficit of just 2 per cent,” and therefore be “more like Germany than Greece.”
If the United States had to pay the interest rates the Italians have to pay, the US would face a game changer, in our view.
The point is: if you look at current interest rates, the world today is upside down and backwards.
Rating agencies only exacerbate the problem. In Europe, they have made such a mess of their ability to forecast creditworthiness that the Europeans are now ignoring the ratings and talking about ways they can create their own rating agencies because of the failure of the ones they used to rely upon.
In the US, the rating agencies now threaten to remove the AAA status of the United States. This is no insignificant issue. The AAA status of the US is the premier credit assessment in the world. It is being diminished, emasculated, and corrupted by American politics. The warnings are very clear by the rating agencies and the central bank leadership. The behavior in Washington is extraordinarily threatening.
A final word of warning: Americans currently are enjoying very low interest rates. At the short end of the yield curve the interest rate is effectively zero. At the longest end of the curve, the 30-year Treasury bond yields somewhere in the low 4% area. The Federal Reserve has practiced a policy to bring those interest rates to that level and keep them there. The Federal Reserve will not be able to control those rates if the world views the AAA creditworthiness of the United States as jeopardized. We saw that in the very short-term reaction in debt markets over the last few days, when there was the first inkling that the debt-ceiling issues will not be resolved in Washington.
The more politicians play brinksmanship, the more they threaten every retirement plan, every beneficiary of a payment stream from the US government, every investor, and every citizen in our country and elsewhere in the world who depends on the creditworthiness of the United States.
Cumberland’s position is based on an assumption that the United States of America will not default. We believe politics will play brinksmanship to the very end and subsequently extend the debt ceiling. The politicians have already introduced cost. There is already a risk premium in the market.
The fundamental assumption is that the US has the capacity to pay, as it has the structure with the Federal Reserve to achieve the liquidity, and in the very end, it will pay its debt and bills in a timely way. Based on that position, we are still fully invested in equity markets around the world and are maintaining our bond positions. That being said, the events suggest to us that a meaningful change in attitude and a permanent cure are not developing in Washington. In Washington, things are done for immediate political expediency, vision is limited to the next election, and the sense of responsibility is deteriorating to a new lower and abysmal level.
Therefore, at Cumberland we will commence a gradual process of shortening duration in bond portfolios. We do not see this as an immediate necessity. We do see it as a strategic shift. Policies that were responding to financial crisis are now running amuck. Our portfolio change will be gradual. When government policies explode in negative outcomes, they are usually received as surprises by markets. A touch of defensiveness is now warranted.
We are heading for Heathrow Terminal 5 tonight. We will be back at our desks on Monday.
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"...Meanwhile, the Italians do not have the ability to use this approach, because their construction with the European Central Bank has taken away the weapon of maintaining their own sovereign debt in their own currency. In the old days, when the Italians used lira, they too had the ability to directly finance themselves.
The victims of the policy difference are the investors, the bond holders, and all those tied to them..."
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The problem is the central banks controlling the fiat monetary system. Their manipulations of the money supply, interest rates etc. is what blew this monstrous bubble in the first place.
I get the impression you think the solution is to double or triple or quadruple down. Let *every* country have their own central bank with their own fiat currency to manipulate the money supply at will.
I disagree.
Where would that type of philosophy stop? Should California and Illinois and New Jersey etc. all have their own central banks and their own fiat currencies to help bail them out?
What about the bankrupt cities?
What about bankrupt companies or bankrupt families?
If only we could print our own money to "stabilize" our economies we could get past these temporary soft spots eh?
No, I think the Austrians have it right. Sound money, free from central bank manipulations would help to stop the madness and would bring far greater stability and prosperity to the entire world.
I think Prof. Roger W. Garrison does a nice job of showing why manipulation of interest rates etc. is deleterious for an economy rather than the boon so many think it would be, in this YouTube clip of a power point presentation he made for a class he presents on "Capital Based Macroeconomics"
http://www.youtube.com/watch?v=zhoFOyy7rbo
This is the most positive thing that I have heard about the rest of the world on ZH.
It eases the tension of my mind after reading daily, for months, about how europe is such a mess. It is a mess, but not nearly as much so as our own dearly beloved US of A. I had never thought about the effect of the 'crisis premium' being the major deficit factor in Italy's budget. Only being off-budget by interest expense is quite a bit different than the problems faced by 'we the people'.
Thanks, Chris, for lessening the distortion of the real world; nice to have a different view than is posted by the groupthink becoming so prevalent here at ZH.
Thanks, Tyler, for posting this piece.
Chris - I have respect for your thinking, your analyses and usually, the views you share here at ZH. This article by David Kotok, doesn't add, doesn't build, doesn't clarify, doesn't deeply examine; it doesn't...
I presume there was something about it that inspired you to submit it for posting.
The Fed has granted the USA time and flexibility absent in Italy, the ratings agencies are part of the problem, politicians of both the Red and Blue coats are part of the problem.
The debts and deficits globally are problematic and have grown from the "free lunch" of reckless fiscal policies akin to handing out skittle covered twinkies to those who have curried favor with contributions to politicians, or from whom politicians seek return to office. The differences are stateless, whether in the USA, Italy, Great Britian, France, Germany, Greece, Spain, Ireland, etc.
So Cumberland is shortening the duration of the bond portion of its portfolio. Is there some great wisdom in that? Any bond fund manager who hasn't been eyeing the end of the great secular bond bull market, must be as wise as a would be home buyer in 2006, buy the dip, because the sky's the limit.
"If Italy could borrow at US rates, then Mackintosh calculates that Italy “would look [to] have a budget deficit of just 2 per cent,” and therefore be “more like Germany than Greece.” ....oh, yeah- Italy's problem is high interest rates on their debt and with lower rates they would be Germans with better food. That's a major joke.
" We believe politics will play brinksmanship to the very end and subsequently extend the debt ceiling."
Exactly... Every picture of the hitters in the recent meetings in the White House shows them all smiling like they are in on a big joke.