Wednesday, November 21, 2018

High Plateau Drifter: "Old Trend - New Trend"

The latest from our old friend High Plateau Drifter:

Last night I watched (once again) the movie The Big Short with Christian Bale as Michael Lewis. It is a history lesson on the crisis of falling housing prices in mid 2007 through 2008 and the mortgage default crisis which accompanied that collapse.

The key point of the movie is the psychology which makes a few people see the obvious in years 2006 and 2007 while most others ignored it. And when I say "obvious" I mean the weakening and exhaustion of a trend in which mortgage finance outpaced incomes thus making a collapse in housing prices inevitable just as night inevitably follows day.

Moving now to present day matters we have the matador moving ever closer to the raging bull of deficit spending armed with only a pocket knife instead of a sword.

The future for financial instruments is baked into the cake.

Federal "Deficit" Federal Debt Increase
For year 2018 $833b $1,271b

Note that the "Debt Increase" includes the interest cost of nearly $400 billion on $15.9 trillion of public debt outstanding, or 2.5% interest (not counting interest on, or principal amount of inter-governmental debt holdings). As you can see, there is an awful lot of rate risk north of 2.5% on outstanding Treasury debt. And given that the President is something of an expert on default and restructuring, I wouldn’t put it past him to try an executive order "cram down."

As of now, only the first 7 years of the post WW-2 baby boom generation (1947 through 1964) had reached age 65 and thus became eligible for social security benefits pictured below. There are another 10 years of baby boomers to go! And in year 2018 Social Security is already costing us one trillion dollars per year meaning that another 10 years of Boomers along with cost of living increases will send it North to 3 trillion. And the big advances in medicine mean we keep more people alive for longer periods of time.

Add to the above the increasing automation of manufacturing and even service industries, and the Red State rebellion that Trump provoked will be much worse and likely turn violent.

Of course those of us who were econ majors in college will wonder how demand is to be maintained when vast numbers of former middle class voters are thrown out of work due to automation. The solution will be a guaranteed income for all – as championed by Bernie Sanders and Ocasio-Cortez. The problem is that as unemployment climbs up the skill and intelligence ladder, at some point the system will be paying money to many capable, aggressive and very angry males. Make them unemployed, and they will have time for face to face communication and the mobility to organize into an irresistible force in ways the system cannot track.
Previously on CBS regarding the bond bear market.
  • Trump will be remembered for inaugurating a bond bear market, and not much else. It is shocking how little discussion there is of the November 2016 "Trump bond crash," and bonds have continued to set new low after new low since then. [March 2018]
  • The financial system wouldn't be so unstable if the Fed hadn't tried so hard to stabilize it. The Fed's response to the bubbles it has created is to blow even harder and hope for the best. The Fed has got itself into a corner and has no credible strategy to get itself out. We know that the latest bubbles must burst at some point and when they do interest rates are likely to rise sharply as bond market investors attempt to dump their holdings. When that happens the financial system will collapse, again. The temptation will then be to prop up bond prices by monetizing what could well be the entire government debt... [November 2017]
  • "[T]he US has a very short maturity structure, so higher interest rates turn into higher debt service quickly. We live on the edge of a run on sovereign debt. The US has a shorter maturity structure than most other countries, and a greater problem of unresolved entitlements. Despite our 'reserve currency' status, we may actually be more vulnerable than the rest of the high-debt, large entitlement western world." [April 2017]
  • Ultimately, debt implies a future transfer of purchasing power, and provides only a few choices. Either you raise adequate tax revenue, or you denominate the debt in long-term bonds and devalue them through inflation, or you default, or you violate the social contract made with those who don't hold paper claims (e.g. Social Security beneficiaries) in preference for those who do. Had the borrowing resulted in productive investment, future output would be easily available to meet those claims. Instead, what’s going on is a quiet dilution of future living standards. [December 2016]
  • [Y]ou're looking at the endgame of a Ponzi scheme that ended when it caused the total fertility rate, and thus - eventually - the worker retiree ratio, to drop too much. To put in a different perspective, the total equity value of the S&P 500 companies is less than $20 trillion. Imagine the federal government exhausting that much capital in ten years. I don't know when it will happen, but I think the bond market will choke. Occasional spikes in bond yields will be the signal that no more can be borrowed. [December 2016]
  • The next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest extraordinary popular delusion. This week has illustrated my point. The election of Trump led to an immediate 25 bp increase in the 10 year bond yield, which means an instant 2.3% loss in value. More than a year's worth of interest. [November 2016]
  • There could be a period when stocks and bonds go down together. For example, instead of stock declines -> people wanting the security of bonds, people might decide that stock declines lead to bailouts which are really stealth currency devaluations, and decide they want no part of the long end of the yield curve. It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. And every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle. If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. [May 2016]
  • We can see with Trump's tax plan (implausible tax cuts and no specific expenditure cuts) that the personalities no longer really matter to the ultimate outcome: sovereign debt crisis, inability to debt finance expenditure, followed by loss of legitimacy of government. [September 2015]
  • Having $3 trillion of assets under management puts you in the top handful of asset management firms. Owning $1 trillion of treasury debt (like China or Japan) makes you one of the largest holders. Who, then, is going to be buying the $3 trillion a year that federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls? [June 2015]
  • For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped. [May 2015]
  • The legitimate purpose of public debt is to borrow money to build infrastructure improvements that have a positive net present value. However, a vast portion of federal expenditure now leaves nothing tangible, leaves no collateral. A treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military "jobs". The lack of collateral makes these treasuries creatures of social mood. In a way, they are as valuable as tulip bulbs or south sea shares. What is a treasury going to yield when mood darkens, and a distressed investor who looks over the enterprise for scrap value is the marginal buyer? [February 2015]
Baby boomers will never be able to accept this psychologically. Baby boomers are accustomed to some asset always going up. If not stocks, then bonds. Hence their 60/40 "diversification" strategy.

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