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The Markets in 2013: Bonds Stink and Other Critical Observations

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Making sense of the 2013 investment climate means considering trouble in the bond markets, social unrest, and geopolitical turmoil.

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The Bond Market Stinks

Despite the increased protests from Congress, there has not been a true movement of disgust toward the national debt. It should be understood that the "bond vigilantes" are the only investors that will force the US government to curtail its massive deficit spending, and until the bond investors coalesce into a rebellion, there will be deficits as far as the eye can see. No amount of doomsday forecasts by newscasters or senators will shock Americans into prudent fiscal behavior -- only the markets can have this effect.

Read the above paragraph again, memorize it, act accordingly.

How Could the Bond Market unfold?
  • Catch-32. Let's assume that, despite the recent tax increases, the economy continues to improve, with stronger consumption and employment filling the headlines. This would be beneficial to the US Treasury because tax receipts would also increase. However, once we hit a moderate level of unemployment, the Federal Reserve stimulus will roll off, and the equity markets will stall or decline as the "covered call" gets exercised. The "covered call moment" will have a psychological impact on consumers and may dampen demand. We could reach a point where the fear of growing beyond our stimulus lifeline stalls the economy. If the fear of a downward swoon is strong enough, it may result in calls for more even more stimulus measures. It is never fun when the "punch bowl" gets taken away from the party.

    Remember that our debt/GDP ratio contains two dynamic variables. Debt can go up, and GDP can go down, and this could push the ratio towards a de facto default. It has happened to other countries, and the US is not immune to a double dip. Let's call our debt problem a "catch-32." You see, once our debt ratio becomes large enough, we will be required to tax $3 for every $2 of spending, because the other dollar will go toward interest payments. Catch-32 is a fiscal mess, and it is sometimes called a death spiral. Rest assured, if we ever see it, the catch-32 will severely crimp economic activity, and it would be the unfolding of the bond market and the US dollar.
  • Geopolitical turmoil. It went relatively ignored last week when the Xinhua news agency reported a Chinese official's lament that:
Washington can still borrow at low costs even when some smaller European economies are completely shut out of the global bond market. But economics and common sense do not lie. People, or governments, can overspend for some time, but they simply cannot live on borrowed prosperity forever. -- Ming Jinwei
You may not agree with the above, but don't ignore it! If China sees better financial returns for its trade surplus in its home market, then the US dollar and the bond market will suffer. Political motivations could fill a similar gap. Imagine if China uses its debt purchases to protest our foreign policy decisions or human rights complaints.

Other sources of geopolitical turmoil include Iran-Israel, Russia, Syria, and the broader Middle East. If the US acts in a manner which requires substantial financial investment to enforce our foreign policy goals, the global bond market might protest. It is plausible that US debt could be scorned, because our debt load is already ridiculously high. Hence, it has been said that a country with economic might has military might; the converse applies. A world with no "cop" is messy and volatile.
  • Crowding out. The Chinese could be required to ramp up domestic consumption measures in seeking domestic stability. If large enough, these measures may result in China running significant budget deficits. At the margin, this will always compete with the US for funds. Our other trusted lender, Japan, has embarked on an economic stimulus plan that will increase demand for borrowing, and this will, as above, compete with the demand for US Treasuries. Europe too remains mired in debt, and looks to the global markets for funds. Granted, the crowding out argument has never been fulfilled despite its intuitive appeal.
  • Social unrest. There is a budding movement of "austerity" in the US -- driven from Republican congressional leaders and other fiscal conservatives. Under the guise of saving the country, there are increasing calls for reducing payouts to Medicare, Social Security, and welfare programs. Ignore the hype! None of these programs will be cut, because if there were significant cuts in benefits, then there would indeed be protests in the streets, and this would indeed result in lost confidence, recession, and reduced financial returns. The reality is that taxes will continue to increase at the fastest rate possible with the only damper being a fear that increased taxation will crimp business growth. If democrats lose their fight to increase the welfare state, then the social unrest could be the undoing of the bond market. Ironically, the expansion of the welfare state during a severe recession has created the debt which threatens to undermine the bond market. Measures to reduce spending will fail, and if they succeed, the bond market will suffer and social unrest will rise.

No positions in stocks mentioned.
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