We're Just Gonna Inflate Our Way Out Of It! (Or Are We...)
From Contrary Investor
We're Just Gonna Inflate Our Way Out If It!...Oh really? I don't think so, Scooter. In a recent discussion we mentioned the fact that lately former Fed member Larry Lindsey has been talking up the idea of a potential fiscal trap for the US. To be honest, we believe this idea has already played itself out in Japan and day by day is coming to a Euro theater near you in terms of individual country experience. The whole idea of a fiscal trap involves the combination of sovereign debt levels with manipulated domestic interest rate levels. Japan has been a poster child example of this simple concept. By artificially holding its domestic interest rates at the theoretical zero bound, it has allowed the government to lever up in a magnitude that most likely never could have happened had free market forces set domestic interest rate levels. Japan has enjoyed an artificial depressant on nominal dollar (in this case Yen) interest costs that has made incredible sovereign debt expansion feel relatively benign from an ongoing debt servicing cost perspective relative to what has been up to this point the magnitude of ongoing sovereign revenue collection.
Many moons ago we were involved with an investment idea for a time that was essentially a rollup of and specialized focus upon ventilator hospitals. The company was called Vencor. As a result of that investment we necessarily needed to get up to speed on the medical profession subspecialty that is pulmonology. And what struck us at the time as being so critical in many patient cases was the "weaning period" or window of opportunity so necessary for a patient to get off a ventilator. In the majority of cases involving a shorter term illness, the weaning period was simply a natural part of total patient recovery. But as you would imagine in a smaller number of cases, patients were not so fortunate. Although this is a very generic comment and completely dismisses patient and circumstance individuality, the fact is that the longer a patient remained on a ventilator, the greater the chances they would not be able to be weaned off of the machine. The body “learns” not to breathe on its own after a period of time. Essentially a patient would pass a critical window of recovery weaning period opportunity.
So, first, our personal apologies as we know this analogy is neither light hearted nor fun to discuss. Somber may be the true characterization. But we believe this analogy is incredibly apt in terms of describing the reality of the sovereign debt fiscal trap. The longer Japan has been on the artificial zero interest rate "breathing machine" over the last decade plus, the harder it has become to wean itself off. Although we could spend an entire discussion on Japan alone, we personally believe Japan has already passed the critical "weaning period" demarcation line for zero bound interest rate/monetary policy. At this point, meaningfully rising rates in Japan would cause a rise in debt service payments that would crash directly into the current level of offsetting revenue collection by the government and leave little else in the way of excess funds in its aftermath. Of course after so many years of zero bound for Japan , investors seem to believe rates will remain near zero indefinitely. This is what complacency is all about. Although this sure seems to be the real world reality that hovers over Japan, the Japanese fixed income markets have clearly not priced this in as of yet. Somewhere down the road it appears an inevitability. Again, a very big story that will be told another day. But when that day comes, it may indeed be quite the eye opener and repricing event for sovereign debt globally.
It just so happens that a few weeks back, those thoroughly lovely folks at the US Treasury Department were kind enough to give us a current look at just where the structure of official US Federal debt stands as of January 2011 month end. We pulled out our calculators and went to work to produce the chart you see below that breaks down the maturity structure of Federal debt by year looking out over the next decade. Let's cut right to the bottom line. A touch over 22% of US Federal debt matures in one year (2011). A touch less than 50% of total Federal debt matures within three years. And as you eyeball the debt maturities of 2011 through 2013, we believe it's fair to say that the average maturity of just shy of half of “official” US total Federal debt is roughly a year and one half. Trying to be conservative, with one year Treasury paper near 30 basis points in cost and three year paper near 100 bp, we believe it's fair to say that a bit less than one half of total publicly traded (excluding intergovernmental transfers) Federal debt has an average cost of capital of about 55 basis points, again remembering that in weighting these numbers the bulk of maturities occurs w/in 1 year. And without question this is a gift of Fed interest rate engineering at the theoretical zero bound. The cost of servicing US Federal debt interest payments has been hooked up to a Fed sponsored ventilator, if you will, as it's certainly not breathing on its own. So the much longer term thematic investment question becomes, just when will the eventual "weaning period" from the zero bound begin and what will be the character of the patient when this occurs?
For now, the US has in good part traveled down the path already trodden by Japan in the prior decade. But as we see life, the US has not yet passed the critical "weaning period" stage where it can no longer "afford" to get off the ZIRP ventilator. Time remains, but the clock is ticking ever louder with each passing day.
Here’s a fun fact you can use to thrill your friends at the next Wall Street cocktail party. At year end 2006, “official” US Federal debt outstanding stood at $4.9 trillion. The latest Fed Flow of Funds numbers tell us that by the third quarter of 2010, that number is now just over $9 trillion, an increase of $4.1 trillion. Not quite a doubling in US Federal debt. To find a similar increase of $4.1 trillion prior to the beginning of 2007, one has to travel back a quarter century and combine ALL Federal debt taken on. We’ve now accomplished in three and three quarter years what took a quarter century to accomplish.
And of course what has happened to 1 year Treasury rates since the dawn of 2007? They have fallen from literally 4.94% to under .3%. You get the picture. The government has been able to take on this magnitude of new debt as debt service costs are negligible under 30 basis points. This is the birth place of the fiscal trap.
Remember, the numbers we are discussing do not include the impact of Fannie and Freddie, nor take into account the present value of SSI and Medicare liabilities. But since Federal debt costs have been artificially lowered for now by the Fed sponsored breathing machine, debt service costs during this period of what truly is unprecedented US sovereign debt buildup have been totally benign. Everyone and their brother know, or better know, that from a longer term standpoint this reality in current US Government funding circumstances is absolutely unsustainable. Somewhere ahead, "something" will change. It's how this set of circumstances is reconciled and what influences or effect this reconciliation has on financial asset classes and prices that will be important to investment decision making.
Sorry to have dragged you through the above, but it sets the stage for hopefully a thematic truism looking ahead. Right to the bottom line. The set of facts and circumstances we've dragged you through so far in this discussion argue incredibly strongly that the US is not going to be able to "inflate its way out" of its current leverage/entitlement obligation position. Of course this thematic comment rests squarely upon the assumption that US interest rates would rise in an accelerating inflationary environment. And yet wildly enough, does it not appear that Fed monetary actions seem absolutely hell bent on reflation at all costs? It sure seems that way.
You know that a few weeks back we received the new budget from the Administration. Of course it came on the same day that the $1.5 trillion budget estimate for 2011 became $1.65 trillion. (You may remember we entered the current year with an estimate of $1 trillion, but who's counting at this point, right?) Of course the missing item from the current budget proposal was any type of an attempt at reconciling entitlement costs. God forbid in a pre-election year, no? C’mon, what’s more important, the long term economic health of the country, or near term election results? Unfortunately and quite sadly, you already know the answer. The key fact in this balance sheet and deficit funding drama is that the US is facing chronic short term budget deficit acceleration due to the now inevitable fact that here and now entitlement costs are accelerating as the baby boom generation has come to collect, so to speak. Since there has never been any attempt by the Government to look at long term funding of these long term entitlement costs (match funding), it's a pay as you go set of programs. And that means the Government long ago chose to fund these short term. Hence the current structure of Government debt maturities. The Government long ago chose to fund its entitlement obligations with an adjustable rate mortgage, if you will. And for now, the chief pulmonologists at the Fed have chosen intubation and ventilator assistance in terms of current interest costs. But the longer the patient (US Government debt acceleration) remains on the artificial interest rate ventilator, the tougher it's going to be to successfully move through and past the "weaning period". Hence the description of the fiscal trap. This is only amplified by the fact that this year SSI inflows will not meet outflow requirements, leaving the Government to make up the shortfall as part of the budget. Just imagine what this will look like in a few years, let alone a decade.
For a minute, let's flip this set of circumstances on its proverbial head and ask under just what set of circumstances could the US Government potentially successfully inflate its leverage problems away. It's a bit of compare and contrast with the reality of current factual circumstances. The US could successfully "inflate away" its debt issues if 1) the structure of debt maturities was decidedly skewed to the long term, and 2) the US had not chosen to fund its longer term entitlement obligations on a pay as you go basis at the short end of the curve. Small annual budget deficits with large long dated debt obligations could easily and absolutely be reduced in "real" terms vis-à-vis a process of accelerating inflation. The problem, per se, could very much be inflated away. But this set of circumstances stands in polar contrast to the current reality of the Federal Government debt structure and ongoing and accelerating short term funding needs. Message being, the US will not be able to inflate its way out of what will be growing budget problems as we move ahead. In fact, the Fed trying to force macro inflation short term is simply counterproductive to Government longer term budget and debt service interests. Question: How does the Fed creating another stock market ramp help to solve bigger picture US debt and ongoing funding cost issues? We do not have an answer, not unless we are going to tax Wall Street and big bank record bonuses as well as stock related capital gains at a 100% marginal rate.
With a projected $1.65 trillion budget deficit for this year, the US will borrow about 11% of estimated GDP. It has likewise been estimated that interest costs to service US Government debt singularly will total about $190 billion, or roughly 1.3% of GDP. Due to the Fed manning the financial ventilator, borrowing costs are low, but borrowing needs are high. With this type of a structural backdrop, inflation (assuming higher interest rates would be a result) is the last thing the US Government needs, but its the very thing the Fed seems intent on provoking. The longer this set of circumstances not only exists, but continues to accelerate in trajectory, the tougher the "weaning process" will ultimately become for the Fed's zero interest rate policy. Unlike Japan , we believe the US still has the time to address this key issue for longer term US economic outcomes. Of course the most important question of all becomes, does it have the will?
The larger the US debt burden grows ahead as the Fed maintains the financial ventilator setting on zero bound, the greater the potential for a sovereign debt dislocation in the US to arise at some point. We are already seeing these exact circumstances in the EU zone along with fallout consequences. We personally believe it will not be long before the global capital markets "recognize" and price in the reality of fiscal and monetary circumstances in Japan . The US given a bit of lead time has a key choice right now. Either deal with this set of colliding circumstances proactively, or the global capital markets will do so somewhere ahead. Unfortunately as sovereign debt issues continue as a critical theme ahead, the spotlights will shine on this problem ever more brightly from a global perspective. We mentioned thematically many moons ago that the final provocateurs in generational credit cycle expansion would be sovereign entities. Just as it was clear in the middle of the last decade that US households were heading toward a generational tipping point in terms of balance sheet leverage extension, so too is it clear now that many global sovereign entities are exhibiting similar character. Unfortunately, our elected and appointed officials, as well as Wall Street and financial sector hangers on, told us "no one could have seen this coming" in 2008 and 2009. We're telling you right now that from a sovereign sector balance sheet standpoint it's coming, okay? We're just hoping we won't be calling ourselves "no one" in a few years.
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