The Daily Reckoning August 1st

Causes of an Unstable Market

So much for the relief rally.

After all the hand-wringing, grandstanding and political showmanship this past week over the debt ceiling, you’d think the Dow would be more grateful than the 145 pop it gave on the open this morning.

Alas, immediately following the open… it sank. As we write, it’s down 45 points.

The culprit? The ISM manufacturing survey tumbled in July from 55.3 to 50.9 — a two-year low.

To say the number violated the Street’s expectations is, um, an understatement: Among 80 economists polled by Bloomberg, the lowest guess was 52.0. Every component of the index indicated slowing growth… and new orders fell into outright contraction.

Whether Congress votes on this deal to raise the debt ceiling or not… there’s plenty of real concerns in the economy to give stock traders the willies.

Likewise, commodities traders are feeling a chilly wind. Manufacturing in China slowed for the fourth straight month.

The June figure of 50.9 fell to 50.7 in July, according to the China Federation of Logistics and Purchasing (FLP), the ISM’s counterpart in the Middle Kingdom.

Within the FLP report new orders look promising… mostly chalked up to domestic demand, not exports. But a separate unofficial gauge of Chinese manufacturing issued by HSBC slipped into negative territory.

Given comments we heard during the symposium last week, we expect an “official” decline in Chinese manufacturing… which, as we noted a few days ago , would drive down prices for the 11 commodities of which China is the largest consumer.

We’ll spare you play by play on the bipartisan deal making its way to the floor of both houses for a vote, possibly tonight. But here are a few cogent plotlines:

• The $2.5 trillion in spending cuts are, in the immutable logic of Washington, not cutbacks at all… but limits to the planned rate of spending increases
• Even better, they don’t don’t kick in until 2013. At that time, a new Congress will be in place, unbound by the promises of the current one.

There’s also a “last minute” mechanism by which $1 trillion of the “cuts” are to be specified now, while the remaining $1.5 trillion — including Social Security and Medicare fixes — are to be hashed out by a special 12-member congressional committee.

It gets better.

The committee will issue its recommendations by Nov. 23 — the day before Thanksgiving. Congress would then vote on the recommendations by Dec. 23 — the Friday before Christmas.

Even if this deal gets the votes it needs, the White House and Congress have done their best to give the can a good swift boot… but made only a glancing impact. The can will have barely moved.

Now the rating agencies face another challenge to their credibility. The big three have spent the last several weeks threatening to downgrade Uncle Sam’s AAA bond rating unless the deal actually gets spiraling debts and deficits under control.

“$4 trillion would be a good down payment,” said John Chambers, the head of S&P’s sovereign ratings committee. The number in the proposed agreement is $2.5 trillion.We daresay that if S&P wants to continue to attract business… it will have to follow through on its threat.

“Eventually, there’s a downgrade coming,” Pimco’s Bill Gross said yesterday. “It just depends on Moody’s, S&P and Fitch, and they’re very slow-moving. This country has $10-12 trillion worth of outstanding debt. In addition, however, we’ve got about $60 trillion worth of liabilities.

“I call this Debt Man Walking.”

“A downgrade from AAA is a matter of when, not if,” writes our short strategist Dan Amoss. “In it’s wake, the dollar index will fall and gold prices will explode on the upside. Such a downgrade would speed up a slow-moving process that has long been under way: the loss of the U.S. dollar’s role as the primary reserve asset for central banks.

“Even the most radical forecasts are off base.

“The Fed will have to ensure that there is no liquidity squeeze — perhaps even reopen the commercial paper funding facility it started after the Reserve Primary Fund ‘broke the buck’ in 2008.

“In short, foreign creditors should accelerate their diversification out of Treasuries and into tangible assets when even the slowest money starts realizing that the positive attributes of the Treasury market — liquidity — are far outweighed by the negatives — never getting repaid in honest money.”

Of the $2.2 trillion in revenue the Treasury pulls in each year, about 10% is going for debt service.

“We’ve had higher numbers before,” said veteran analyst Adrian Day on Friday during our symposium in Vancouver. “But rates are now at 70-year lows. And more of the new debt Treasury is issuing these days is of short duration… because those rates are lower.”

Just a reversion to “normal” interest rates… never mind a downgrade… would quickly drive up debt service to 30% of revenue.

This is a reality foreigners already recognize… which is why they’re buying fewer U.S. Treasuries. China’s Dagong rating agency gives its top ratings to Norway, Denmark, Luxembourg, Switzerland and Singapore. Among the world’s nations, Dagong ranks the United States No. 13.

If foreigners got serious about fleeing Treasuries, the heavy lifting would fall once again to the Federal Reserve. As yet, the Fed has already bought up 80% of Treasury debt issued in 2011.

“There’s something dramatically wrong when one arm of the government is creating money to buy the debt of another arm of the government.”

Amen, Mr. Day.

“This whole wrenching effort to shrink the debt may actually increase the debt,” explained an AP story anticipating a downgrade.

A downgrade “could increase the cost of borrowing for the government — hence more interest and debt — not to mention for everyone else.” Not the least of which are state and local governments who received 80% of the last round of stimulus.

Regards,

Addison Wiggin,
For The Daily Reckoning

Causes of an Unstable Market originally appeared in the Daily Reckoning. The Daily Reckoning provides 400,000+ readers economic news, market analysis, and contrarian investment ideas. Follow the Daily Reckoning on Facebook.

Back-Slapping Sellouts

It’s a deal!

As expected…the papers are announcing that the Repubs and Demos have made an historic deal.  With the solemnity and gravitas that the occasion calls for, they have come together, after great and profound debate, to join hands…

E Pluribus Unum, they said… We may have different ideas on the subject, but when it comes to the interests of the whole country, we can nevertheless work as one body, with one heart, and one digestive system…

…and so they crossed aisles…and clenched hands…and slapped backs…

…and the brightest and best…the leading statesmen, leading scholars, leading orators and rhetoricians of the world’s greatest hegemon, all came together at the last minute…

…and agreed to continue debasing the currency and credit of the United States of America.

Hallelujah..  Hallelujah… We are saved!

All over the world, shouts of Hosannah go up…along with stock prices.

And the US economy sinks…

“Great Recession Even Deeper than Thought,” says a headline at MarketWatch.
Than WHO thought?   Not our Dear Readers.  We knew there was no recovery…and that what we’re dealing with is a correction of epoch scope and power.  The article continues…

WASHINGTON (MarketWatch) — The U.S. recession was even deeper than previously thought, a new government report showed on Friday.

As part of an annual revision of data on U.S. gross domestic product, the Commerce Department said that the economy contracted by 5.1% between the fourth quarter of 2007 and the second quarter of 2009, more than the 4.1% previously estimated.

It ranks as the most severe recession in the post-World War II era. As a result of the revision, GDP is now still below the pre-recession peak, economists said.

Before the revision, it was hard to square an unemployment rate above 9% with the economy’s growth rate.

Under the revised data, the U.S. economy declined 0.3% in 2008, weaker than the prior estimate of a flat reading.

The contraction in GDP for 2009 was revised to 3.5%, much weaker than the previous estimate of a 2.6% decline.

The real story is worse than that.  Almost all the “growth” since ’07 has not been growth at all…but just the result of US government transfer payments.   The private sector – which is where real wealth is created – continues to sink.

Also, we know we’re in a powerful correction.  But we still don’t know exactly what this correction is correcting. Stay tuned…

Regards,

Bill Bonner,
for The Daily Reckoning

Back-Slapping Sellouts originally appeared in the Daily Reckoning. The Daily Reckoning provides 400,000+ readers economic news, market analysis, and contrarian investment ideas. Follow the Daily Reckoning on Facebook.

The Sound That Washington Made

Clang-clang! Clankety-clank! Clang-clang!

Do you hear that sound, dear reader?

Hmmm…if we are not mistaken, that’s the sound of someone kicking a can down the road.

Oh wait…no…that’s the sound of Congressmen kicking a can down the steps of the Capitol building, out into the streets of American taxpayers…present and future.

As we finish up today’s edition of the Daily Reckoning, an “historic vote” is underway in Washington D.C. We do not yet know the results of the vote, but we already know the outcome: more of the same.

The newswires are abuzz with headlines of a breakthrough budget deal between Republicans and Democrats.  Most of the headlines portray the deal as something epochal, extraordinary… even revolutionary. But the deal on the table is nothing but ordinary, par-for-the-course, more-of-the-same, political cosmetology.

This “groundbreaking” agreement between the two leading political parties promises to “cut” $2 trillion in spending over the next 10 years.  That sounds like a lot of money.  But there are at least two big problems with the math.

First, a cut in spending, as Washington defines it, is rarely a reduction in current spending. It is usually a reduction in planned future spending increases. If you or I cut spending the way Washington cuts spending, for example, we would not save $10,000 per year by canceling our golf club membership, we would “save” $10,000 by not joining the tennis club we were planning to join next year.

Returning to the real world for a moment, even if the $2 trillion of planned savings were savings as most of us would define it, the number is still much too small to make any difference. A $2 trillion spending cut – over 10 years, mind you – is a rounding error in the context of America’s $75 trillion – roughly – of total outstanding debts and future liabilities.

In the first two fiscal years of the Obama administration, alone, the United States amassed fresh debts of $2.7 trillion…which leads us to the Daily Reckoning question of the day:

If the government can effortlessly incur $2.7 trillion of fresh debts in just two years, why does it need a decade to cut spending by $2.1 trillion?

Answer: Clang-clang! Clankety-clank! Clang-clang!

Nevertheless, the announcement of the budget deal is likely to produce a knee-jerk bounce in the dollar and in equity markets around the globe… for a while.  Precious metals, on the other hand, are likely to slip for a bit. But these moves – stocks up, gold down – would be counter-trend blips, signifying nothing except investor hyperactivity.

The underlying fundamental trends in United States do not inspire confidence.  In fact, raising the debt ceiling in exchange for meager spending cuts over what might as well be an eternal timeframe does not improve America’s credit-worthiness one iota; it merely allows her to become even more insolvent.

Imagine your uncle came to you, asking to borrow some money. Your uncle earns about $100,000 per year, but he already has half a million dollars of outstanding unsecured debt. He promises to reduce his half-million dollar debt load by $14,000 over the next ten years, if you will merely lend him $7,000 today.

Would you lend your uncle the money?

Probably not…unless your uncle’s name was Sam and you had no choice in the matter.

Buy gold…still.

Regards,

Eric Fry,
for The Daily Reckoning

The Sound That Washington Made originally appeared in the Daily Reckoning. The Daily Reckoning provides 400,000+ readers economic news, market analysis, and contrarian investment ideas. Follow the Daily Reckoning on Facebook.

The Great Correction: 5 Years On…Part II

You will recall.  As we ended last week, we were speaking to a crowd at the investment symposium in Vancouver, Canada.  We had introduced the provocative idea that maybe the course of history was not something we could understand or control.  Maybe destiny, fate, or grand historical forces were at work.  We can barely understand them, let alone control them, we argued.  As for fighting against them, fugitaboutit.  Our speech continues…

Addison chose the “Fight or Flight” theme for this year’s Agora Financial Investment Symposium. Addison is a fighter. He’s devoted a considerable amount of his time…and a considerable amount of my money…to trying to save the nation.   His latest documentary, RISK!, which I didn’t get a chance to see, shows how innovation, creativity and entrepreneurship can put some life back in the economy.

It’s a very optimistic way to look at things.  And maybe that is the destiny of the United States of America.  Or maybe it isn’t.   But let me give you an example of the kind of thing that might lead to a much different outcome.

First, we have to understand.  The US has an empire…it is an empire.  We don’t think of it that way, because we still call the US leader a president.  He is elected…as are congressmen and senators.  So, it doesn’t seem much like an empire.  But in critical aspects, the US has followed Rome on the path of empire.  The US is the world’s leading power…with much more of a monopoly on military force than any empire in history, including Rome itself.  Rome had the barbarians to the North and the Parthian to the East.  Neither could it ever subdue.  America has almost no competition.

But what does it matter what happened to Rome?  That’s ancient history.   Most Americans don’t bother to think about it at all.  And they certainly don’t think that it has a destiny that cannot be checked or escaped.  Americans don’t believe in Fate.  Or destiny.  They think they can do whatever they want.  They think their future is up to them, completely.  They just have to get their leaders together to vote on it!

And yet, every empire ends up broke…and defeated.  And the fate of every country that has tried to run a pure paper money system…with currency not backed by gold…has been disaster.  The fate of every country has allowed debt to get out of control has been disaster.  It didn’t matter what anyone thought or did.  Once you head down that road, it seems that you have to go all the way.  I guess, there are a lot of byways and side-roads you can take.  But you always seem to end up in the same place.

But maybe Obama is smarter than, say, Ceasar Augustus or Marcus Aurelius, or Diocletian.  And maybe Bernanke and Geithner are smarter guys than, say, John Law or Karl Helfferich or Domingo Cavalho.

Maybe Obama, Bernanke, Summers, Geithner and all are such geniuses as to be able to do what no leaders or experts have ever been able to do before.  But I wouldn’t bet on it.

The US currency used to be fixed to gold.  No one had to manage it. We didn’t need geniuses.  But since it has been actively managed – by people Bernanke and Geithner, and their predecessors – it has lost 97% of its value.  What are the odds that these managers will do better in the future?  What are the odds that they will succeed where all the central bankers and central financial planners who came before them failed?

So, if you expect to hold the US dollar for a long time, you’re betting on something that has never happened before.  And you’re betting on the genius of the men and women who, so far, appear retarded.

One thing you learn from reading the history of Rome is that the imperial bargain is a tough one.  You get glory.  But you pay dearly for it.  The middle class is destroyed…and the country goes broke.  That’s the destiny of empires.

You know, most of you have probably watched the value of your houses go down.  They’re down about a third on average.  Well imagine how you would have felt as a citizen of Rome after the empire hit its peak under Trajan in about 100 AD.  You would have watched the value of your real estate go down…and not come back for 1800 years.  There were still goats grazing on 7 hills of Rome – once the world’s most expensive real estate –when English tourists visited in the 19th century.

But those of you are a confident that the US will always be a winner won’t believe me.  You believe that that right-thinking, well-intentioned public servants will always find solutions…that they will always do the right thing, at the last minute, perhaps.  You think Europeans may get themselves out of an impossible situation.  Ha, not us!

But what I notice is that while Europe is broke…the US is even broker.  And while Europe can probably recover from its debt problems, the US probably can’t.

“Europe is unraveling as we speak,” said John Mauldin on Tuesday.   “The euro will probably not exist within two years.”

I told John I thought he was wrong.  So he challenged me.  In 2 years if the euro is higher than the dollar, he’ll pay me $100.

I told him I’d rather have euros.

John may be right.  He thinks the US has a big advantage.  Because it has a political union as well as a currency union. It can force all Americans to pay for debts run up by just a few of them. It can apply one interest rate…and make it work for the entire country. It can put the full faith and credit of every village, borough and backwater at risk…in order to bail out its banks and pay for its central planning experiments.  It can increase its debt and debase its own currency almost indefinitely – simply by an act of Congress, raising the debt ceiling.

That’s what people think.   No destiny involved.

Europe, meanwhile, is hamstrung and hog-tied.    It has no centralized political management, so it cannot force Germans to pay for Greeks’ spending, for example.  Interest rates suitable to German savers are demonstrably unsuitable to Italian spenders.   And member states of the European Union are given to all manner of silly spending.  Italy is sinking under the weight of too many limo drivers. No kidding. Chauffeurs for public officials form a substantial part of the Italian government budget. And don’t forget the bunga-bunga parties, too. The Greeks, meanwhile, can’t collect taxes. France gives away far too many social benefits; it faced massive strikes when it raised the retirement age to 62. And Ireland should never have bailed out its insolvent banks; it didn’t have the money.

To an American crowd these reports from Europe look like evidence of the superiority of the US model. The US may default, they say, but it would be just a voluntary, technical default.

“Compared to Europe,” John continued, “America looks like it is well run.”

To us, the US and its whole capital structure – its stocks and its bonds — looks like a trap.  And the tension on that trap is illustrated by current yields on government debt obligations.  Greek 2-year debt was still yielding over 30% when last we looked.  US 2-year debt yields are so low, there is nothing but a zero on the left side of the decimal.

Greece and the US have about the same amount of government debt to GDP.  So does Italy, depending on how you calculate it.  Italy actually has a much lower deficit – not even half the US.  So why the higher interest yields in Europe?  Addison’s movie suggests that America can still harness its traditional strengths…innovation, flexibility and entrepreneurship…to re-invent itself.  But the America that led the world in growth and output, did so largely by trailing it in central planning as well as pettifogging, paper-pushing regulations. Now it leads the world in central financial planning, debt and regulation. Will it lead the world in growth and innovation too?   I doubt it.

More to come…

Regards,

Bill Bonner,
for The Daily Reckoning

The Great Correction: 5 Years On…Part II originally appeared in the Daily Reckoning. The Daily Reckoning provides 400,000+ readers economic news, market analysis, and contrarian investment ideas. Follow the Daily Reckoning on Facebook.

Rating Agencies Capitalized on the Debt Ceiling Fiasco

Now, as anticipated, a debt ceiling agreement has been reached and the wait is on to see whether the major rating agencies — Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings — will reaffirm or downgrade the US’ triple-A status.

A credit rating downgrade any time in the near future seems unlikely. Instead, Liz Peek at The Fiscal Times suggests the ratings agencies have simply been exploiting the debt ceiling drama in an opportunistic media push to regain some credibility after their many blunders, just a few of which are highlighted below.

From The Fiscal Times:

“Their role in aiding and abetting the purveyors of the now-infamous CDSs and CDOs, by providing unwarranted triple-A ratings, was not the first in which Moody’s and S&P had been caught wrong-footed. Both companies had failed to unearth the chicanery at Enron and WorldCom, for example, though a small rival named Egan-Jones had blown the whistle on those companies before they went under…

“…Criticism of the ratings agencies is not confined to our shores. In the past several weeks, monetary authorities in Europe accused the firms of “bias” after Moody’s downgraded Portugal’s debt to junk status. European Commissioner President Barroso suggested that the EU should begin looking for alternative sources of guidance for their debt, and was quoted as saying “We must break the oligopoly of the ratings agencies.” Other observers noted that, as usual, the agencies were actually behind the curve on spotting the deterioration in EU debt; the credit default swaps markets had forecast the slide months earlier.

“For all these reasons, there is ample incentive for Moody’s and S&P to try to get ahead of the U.S. looming debt crisis. Despite their history, their input has been welcomed — treated as oracular, even — by our political leaders. For both sides in the debate, alarm bells rung by the agencies have served a purpose. It has allowed President Obama to chastise the GOP for not responding to the gravity of the debt crisis; at the same time it has allowed Republicans to press their case for spending cuts. Unhappily, unless the two sides in this debate emerge from their bunkers and manage to fashion a meaningful compromise, the ratings agencies may well have to follow through and downgrade the nation’s debt, conceivably costing taxpayers hundreds of billions of dollars in higher interest on the federal debt in years to come.”

The ratings bias Peek discusses is readily apparent… toward the companies that pay for ratings, a clear conflict of interest, and, of course, toward the US. (Also, arguably against Chinese debt.) The US bias likely stems from the fact that this nation’s very own Securities and Exchange Commission decides which rating agencies qualify for status as a Nationally Recognized Statistical Rating Organization (NRSRO), an essential designation for making a credit rating agency relevant to investors.

Of course, whether the manipulation even matters is another question entirely. As Quantum Fund co-founder Jim Rogers recently suggested, the US has already lost its AAA status among sophisticated investors. Ratings agencies have been drumming up attention so as to not be late, again, to the downgrade party… but this party’s already long over. You can read more of Peek’s opinion in her Fiscal Times piece on how rating agencies are exploiting the debt drama to regain trust.

Best,

Rocky Vega,
The Daily Reckoning

Rating Agencies Capitalized on the Debt Ceiling Fiasco originally appeared in the Daily Reckoning. The Daily Reckoning provides 400,000+ readers economic news, market analysis, and contrarian investment ideas. Follow the Daily Reckoning on Facebook.