Atlas is Shrugging May 20, 2009

"I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.

~ James Carville, Campaign Advisor to President Clinton,
in the Wall Street Journal, February 25, 1993, p. A1

Having navigated his political career through the 70s and 80s, James Carville understood the power of the bond market as a measure of fiscal irresponsibility. As a former bond trader myself, having learned my trade from former bond vigilantes of this period, I can also attest to the power of the sleeping giant that is just awakening from a twenty year hiatus of declining interest rates. I can also tell you that this giant awakens at the smell of profit and opportunity from one of the best bearish bond market moves to be seen in many years. Furthermore, I can assure you that this move will last for many years.

It's funny how the pundits of Wall Street and MSNBC have neglected to mention that, from their December 2008 lows of 2.56%, yields of 30-year US Treasury Bills have risen 43% in the last five months to a high of 4.38% at the end of April. This, to me, is very bullish as it signals that bond investors are starting to review the ability of the US Government to cover their current and growing future liabilities, and the conclusion can only lead to higher yields. Let's review.

The first piece of evidence is the yield increase itself. At the same time that the Fed has been "monetizing their debt, or printing money to buy its own debt, yields have increased. This leads one to conclude that some people (such as foreign governments) must be selling a greater amount of Treasuries than are being repurchased. This is also reinforced by the April Treasury International Capital (TIC) Report, which showed that, for January and February, there had been net outflows of Treasuries. The recent spike in yields occurred the same week that $300 billion in Treasury Bills matured and needed to be refinanced — this also suggests that future TIC reports will show greater outflows of Treasuries by foreign investors. In essence, investors do not like what they see regarding the US Government's ability to pay back these mounting liabilities.

A second piece of evidence is the White House's own May 11th report that projected the 2010 deficit would come in at $1.86 US trillion instead of the $1.25 US trillion projected three months ago. This amount does not include the other $650 billion in debt that is maturing in the next twelve months, or the $700 billion in Troubled Asset Relief Program (TARP) bailouts already promised, bringing the total amount needing to be funded over the next twelve months to $3.21 US trillion. Of greater concern is the fact that total debt to GDP is going from about 35% to about 70%, a 100% increase. These assumptions also assume no new bailouts (GM not included) and a constant cost of borrowing. Another issue of concern is the political vilification of GM's debt holders,who are being asked to share the burden and give up their legal rights to these liabilities. This will not show well to foreign debt holders who might someday also be asked to share this burden.

A third piece of evidence is the debt monetization process itself. It always works at the beginning, as it is logical to expect that interest rates will decline as the inflows start. However, the debt monetization process also assumes that somebody will be there at the end to repurchase the debt. For some reason, Central Bankers always seem to forget that, historically, there have not been many buyers willing to assume the overextended liabilities of fiscally irresponsible governments that apply debt monetization. This lack of refinancing always leads to much higher interest rates, inflation and lower currency value.

These trends—increasing amounts of debt, government justification for non-payment, increasing cost of borrowing, and debt monetization—only lead to a long-term trend of increasing interest rates. This is very bullish for the rational investor who understands that, since interest rates will only increase from here, one might just as well position oneself to benefit.

“There is a crack in everything, that's how the light gets in.”

Leonard Cohen said it best in that it is necessary to get these cracks in the system, so that the system can cleanse itself.

This update reflects the purpose of my practice: to understand the coming changes and assist you in making wise investment considerations that will help to benefit your portfolio.
Jaime E. Carrasco, BA, CFP
Investment Advisor
T: 416-864-3623
C: 416-271-6630
E: jcarrasco@blackmont.com