Yesterday on Tom Keene's always informative show, two of the world's most important economists, Goldman's Jan Hatzius and BofA's Ethan Harris presented their respective defenses for why GDP in 2011 would rise by nearly 4% as per their recent predictions. The straw man for the upside case: recently adopted fiscal stimuli which, however as David Rosenberg notes, are not really stimuli as much as lack of governmental disstimuli. Yet what is interesting is that both ceded that both employment and housing, the two key traditional drivers of economic growth and prosperity, would likely continue deteriorating, with employment ending the year over 9%. In other words, all growth in 2011 will be predicated upon very much more of the same: transfer payments and government stimulus (not to mention inventory accumulation) especially in the form of incremental debt to offset consumer deleveraging. No surprise there. After all the only reason why the economists of the world have expressed an unprecedented amount of bullishness in recent months is that the US is currently experiencing a rare confluence of both fiscal and monetary stimulus: an even that last occurred in March of 2009. The issue is that as we have noted previously, the benefit from the fiscal stimulus has already been negated by the jump in oil and other commodity prices, whereby the token weekly paycheck increase has been more than offset by gas price increases, while the monetary stimulus is already priced in, and absent rumors of another episode of QE in advance of the June end of QE2, the temporary stock market strength will quickly turn into weakness. Which leaves us with the hangover effect of federal deficit... and its funding. The chart below presents some interesting observations in this regard, and also makes us wonder just what will happen to risk assets if Bernanke does not leak the announcement of QE3 by May at the very latest.
Looking at deficit and debt issuance on an LTM basis, we may have reached another inflection point. While the trailing 12 month deficit jumped, and has stayed, over $1 trillion since March 2009, it had at least stayed relatively flat on an LTM basis. As of the November data, however, the LTM trendline has hit a support level and has bounced up. It is very likely that with the need to fund the payroll tax cut this trend will continue deteriorating. In fact, we expect that by the end of 2011 the LTM deficit to be right back at $1.5 trillion. And the other notable inflection: over the past quarter, the debt issuance over the deficit, which had averaged roughly $300 billion on TTM basis, jumped to approximately half a trillion. This is precisely the key part of the double whammy of the "negative convexity" of debt issuance used to fund deficit payments. As for the second one: once rates start picking up, and incremental debt issued by the US starts pricing with a higher cash coupon, increasingly more debt will have to be issued to fund merely the interest expense.
Nearly a year ago, we conducted a sensitivity analysis looking at what the annual interest expense would be as a function of treasury receipts. We concluded that should the average interest rate on US debt rise to 5%, the annual interest payment on the debt would jump from roughly $180 million to almost half a trillion, or roughly 25% of all revenues, at which point the Weimar scenario starts getting quite realistic. Needless to say we will update this analysis shortly, especially now that rates are not only rising, but projected to go up to 4.5% or higher, courtesy of the abovementioned "economic improvement."
But back to the chart: now that we have already managed to extract the benefits from the front-loaded benefits package, all that remains is the cost. And the cost in question is debt issuance risk. Which simply means that like last year, when well over $2 trillion in debt demand was unaccounted for, and subsequently satisfied by QE Lite and QE2, in 2011, when we predict net debt supply will hit another all time record, Ben Bernanke will have no choice but to enter the Treasury purchasing market once again. In other words, we expect that Jon Hilsenrath will circulate an article highlighting the ever greater likelihood of another round of quantitative easing some time in April... just a few weeks after the most recent debt ceiling vote passes, this time allowing the US Treasury to issue up to $15.5 trillion in debt, or $1.2 trillion more than the current token limit- just enough to kick the can one more year down the road.
On the other hand, if we are wrong, and if Ron Paul somehow succeeds in preventing this form occurring, then all those market "strategists" who expound the benefits of the economic "recovery" when all they expect are further rounds of QE, will promptly change their tune.
In other words, the entire fate of the market's 2011 closing print will depend on that critical window between April and May when QE3 may or may not be announced.
Below we present the Hatzius-Harris interview with Tom Keene.