James Pethokoukis

Good luck to the Obama deficit commission. In my heart, I do not believe Congress will pass huge entitlement cuts (preferable)  or tax increases without a  crisis.  (There needs to be a focus on boosting economic growth.) To quote Milton Friedman in Capitalism and Freedom:

Only a crisis—actual or perceived—produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable.

Here is one crisis scenario, as outlined by the Committee for a Responsible Federal Budget:

If low interest rates lead to continued debt accumulation and then suddenly, creditor preferences shift, we could experience a “catastrophic budget failure” as set out in a recent paper by Len Burman of the Maxwell School at Syracuse University and his colleagues at the Tax Policy Center.

Under this scenario, at some point financial markets or foreign lenders decide we are no longer a good credit risk, possibly due to debt affordability concerns. They conclude the United States cannot escape basic economic and financial “laws of gravity” forever. They stop buying our debt securities or demand dramatically higher interest rates due to increased perceived risk. With the sudden shift and large rise in interest rates, the economy goes into a severe recession. (“The longer it takes for the crisis to occur, the worse it will be.”) Unlike the past two years, we cannot, however, borrow to stimulate the economy because the crisis was caused by excessive debt and lost confidence. “In the extreme case, the U.S. may not be able to borrow at any interest rate.” Creditors concerned with hyperinflation or even default will not buy U.S. debt.

This from Ed Yardeni, keying off a recent Charlie Gasparino’s column:

There is no one in the Obama administration like Robert Rubin, who had the ear of President Clinton. Rubin convinced Clinton that the Bond Vigilantes would riot if he pursued policies that would lead to a structural federal deficit, i.e., one that would widen despite a growing economy. So far, the Bond Vigilantes haven’t gone on a rampage despite projections of $10tn in deficits over the next 10 years. So it is no wonder that Obama’s political advisors are acting as though they’ve been handed a blank check by the bond market. However, the longer they ignore the economic advisors, the greater is the likelihood that the blank check will bounce.

Me: Indeed, at a think tank conference I attended yesterday, both Rubin and Roger Altman expressed great concern about the deficit. They definitely seemed to want budgetary action sooner rather than later. Actually, they implied financial markets will demand it.

The Cleveland Fed gives the bad news:

First, without a correction on the spending side, more tax revenue will need to be raised, with the consequence of subjecting the economy to greater tax-associated inefficiencies.

The risk of default may also increase, leading to higher risk premiums, higher interest payments, and a greater cost to be sustained in the future to address the fiscal imbalance.

In addition, a sustained demand for funds by the government sector will likely put upward pressure on future real interest rates, with adverse consequences for private investment and growth.

The increase in domestic interest rates will likely attract further financial flows from countries with higher saving rates, which may lead to a dollar appreciation and a worsening of our current account deficit.

This has been the major, major shift in the structure of the US Treasury market that was unanticipated. From Q1, US households held $643.9 billion in Treasury debt and that is up from $256.6 billion in Q4 2008. Households bought an astounding 84% of new US Treasury issuances in Q1. The total holdings represent about 1% of US household assets. According to the WSJ, “Although that is the highest since 2001, Treasurys regularly made up 5% of assets in the 1950s, and as recently as 1995 they were 2.6% of assets. History suggests there is plenty of room for households to increase their holdings.”

With the US current account shrinking, the US is less dependent on foreigners to fund it’s deficit as the trade red ink has slowed to below $10 a month ex oil. In the medium term, this is a strong positive for the US dollar as it means the United States is funding itself more domestically. The longer term issue is whether the United States continues down the fiscal path of becoming the Japanese where domestic savers fund a fiscal deficit that is above 180% of GDP.

Fear of massive deficits and inflation may or may not be driving up interest rates, but the impact of the rate rise is not up for dispute. This from Barclays:

Mortgage rates jumped to their highest since November, stifling refinancing

The Mortgage Bankers Association’s index of mortgage applications fell 7.2% w/w in the week ending June 5, marking the third consecutive weekly decline. The downturn owes to a sharp drop in refinancing activity as a result of higher mortgage rates.

The index of refinancing applications fell 11.8% in the latest week, pushing the index to the lowest level since November of last year (Figure 1). The index of purchase applications inched up 1.1%, leaving the four-week moving average up 0.5%.

The average rate on the 30y conforming mortgage (as measured by the MBA) jumped 32bp to 5.57%, also the highest since November. Mortgage rates have jumped more than 100bp from the trough of 4.62% at the end of April.

This chart from Jim Glassman of JPMorgan makes an argument about seasonality:

Whatever the politics, fixing Social Security is easy conceptually.  And if Team Obama is starting to get a bit anxious about an adverse reaction from the bond market to its fiscal policies, why not offer a fix as evidence of its seriousness about America’s entitlement woes? Here is Ed Yardeni on this very topic:

The Obama Team needs to negotiate a peace treaty with the Bond Vigilantes. The Administration will agree to slash the structural federal deficit. The Vigilantes will stop pushing bond yields and mortgage rates up to levels that will abort the recovery. This would be a win-win solution in the spirit of doing what is best for the country. The President could do what Nixon did. It took an anti-communist hawk to recognize Red China. It may take a liberal community organizer to address the looming financial crisis in the social welfare state, particularly Social Security and Medicare. Now is a good time to push for means testing of these two programs. Actually, there is already some means testing in both programs, but the testing should be expanded. The programs shouldn’t be entitlements. They should be insurance programs that provide a safety net for those who are truly in need of public assistance. If the Obama Administration seriously addresses this issue, the outlook for the structural deficit will improve dramatically. In this scenario, both Treasury bonds and the US dollar could rally as the Administration actually delivers on its promise to reduce the structural federal deficit.

Me:  I wonder if bond investors are more worried about inflation, default or inflating to avoid default? I would also be concerned that any Obama solution would include higher payroll taxes. Some economists blame FDR’s institution of a payroll tax in the 1930s for extending the Great Depression. Raising the retirement age and linking benefits to inflation rather than wages would actually create huge budget surpluses, by the way.

I think strategist Andy Busch of BMO Capital Markets makes a great point in his morning note:

The issue of the radical fiscal experiment that is now underway in the United States is dominating stock, bond, and currency markets.  During World War II, the US debt had exceeded the size of GDP and had to be reduced by draconian methods.  The US is embarking upon a debt issuance program which is on track to take the debt total back above the size of GDP.

Will America’s lose its AAA S&P bond rating? Not anytime soon, says the econ team at Wachovia:

Any downgrade to the United States’ bond rating is not imminent. Some analysts speculated that any downgrade, should one even occur, probably would not happen for 3 or 4 years. In response to the concerns over the government’s fiscal position, Treasury Secretary Geithner said that the Obama administration is committed to bringing the budget deficit down “to a sustainable level over the medium term.”

Concerns over the U.S. fiscal outlook are not likely to disappear just because the Treasury Secretary uttered a few reassuring words. Therefore, the dollar could remain under downward pressure, at least in the near term. However, the scrutiny on the U.S. fiscal outlook will probably fade over time, and investors will likely start to re-focus on growth prospects.

Relying on the Fed cannot be the sum total of an economic policy to increase economic growth. In fact, current Fed policy may well be saving the U.S. banking system, but it is hardly setting the stage for a robust economic recovery. Scott Grannis (Calafia Beach Pundit) notices the rise in 10-year yields (bold is mine):

The Fed is trying to fight a force of nature—the bond market—and they are bound to lose. Purchasing long-maturity Treasuries, mortgage-backed securities or corporate bonds in an  to keep their yields low is a self-defeating strategy …  Ultimately, inflation and inflation expectations are what drive bond yields. If the Fed buys too many bonds, rising inflation expectations will kill the world’s demand to own bonds, and yields will rise. … So far this year, the yield on 10-year Treasuries has risen from 2.05% to 3.4%, and that is just a down payment on the eventual rise. … As politicians should know (though they refuse to believe), the economy is not something that can be easily manipulated according to their whims or preferences. As the Fed should know (but amazingly they seem to ignore this), long-term interest rates are set by market forces, not by the Fed’s Open Market Committee, whose only job is to attempt to control very short-term interest rates. Rising 10-year yields will put a floor under conforming mortgage rates, which have most likely already hit bottom. Yields on jumbo mortgages still have room to fall …

Indeed, one shouldn’t mistake a healthier banking system for an economic recovery, so says David Goldman (Inner Workings bl)og, noting the price rise in commercial MBS:

Distressed assets yield enough to compensate for high losses elsewhere. The zombie strategy, in short, is working out just dandily, thank you. This means: No collapse of US national credit for the time being, and lower volatility (hedging costs) overall — but NOT economic growth.