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The Case for Higher Treasury Yields... and Lower
REIT Prices |
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A $3.8 trillion dollar budget...and the "rich tax" proposed to pay
for it,
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Debts and deficits: Putting those spending proposals into
perspective,
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Plus, Bill Bonner on governments gone wild and other dirty
laundry...
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Eric Fry, reporting from Laguna Beach, California...
In yesterday's edition of The Daily Reckoning, our resident
short- selling specialist, Dan Amoss, explained why he believes REITs -
and especially hotel REITs - offer a delectable short-selling opportunity.
Dan returns today to punctuate his bearish analysis of the REIT sector
with an equally bearish analysis of Treasury bonds. "I'm a bear on
Treasury bonds," Dan says unapologetically. "Prices should go down and
yields should go up as the creditworthiness of the US government
deteriorates."
If long-term interest rates were to rise as much as Dan expects, the REIT
sector would suffer more than most other market sectors. REITs are
interest-rate sensitive on at least two fronts. First, since most REITs
used borrowed funds to amass their property portfolios, any increase in
interest rates would increase their cost of capital, thereby squeezing
profits. Secondly, most investors consider REITs "yield instruments." As
such, REITs, much like bonds, will rally when interest rates are falling
and fall when interest rates are rising.
In the column below, Dan presents persuasive arguments for selling
long-dated Treasury bonds. But first, please allow your California editor
to perform a warm-up act by providing his own argument for selling
Treasury bonds. Your editor's argument is embarrassingly simple: Sell
bonds because the US government is borrowing crazy amounts of money.
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As the nearby chart illustrates in grisly detail, the US government has
amassed $1.8 trillion of new indebtedness during
the last 15 months. Astonishingly, each and every one of the last 15
months produced a deficit, including the tax-collection month of April,
which had produced a surplus for 26 straight years.
So how much is $1.8 trillion, anyway?
Well, let's see... It's about 13% of US GDP. $1.8 trillion is also about
double what the IRS collected from all individual taxpayers last year. In
other words, if every American taxpayer had simply agreed to double his or
her tax payments last year, the nation could have avoided this whole
deficit mess.
For one final bit of perspective, $1.8 trillion is more than double the
total debt America had accumulated during its first 200 years as a nation.
America's debt load did not crack the trillion-dollar level until after
1980. These days, we rack up 200 years worth of debt every six months or
so.
Thus, from a purely mathematical standpoint, trillion-dollar annual
deficits seem incongruous with 30-year Treasury bonds yielding less than
5%. Less than 20%, maybe.
The initiatives that are aggravating America's runaway budget deficits are
so mindless and uncoordinated they are, to paraphrase White House Chief of
Staff, Rahm Emmanuel, "profanely moronic." As these moronic initiatives
pile trillion-dollar deficits atop one another, Treasury bond yields might
go to 20% at some point...or the dollar might go to three euros...or both.
For more about what's wrong with Treasuries, check out Dan Amoss' column
below...
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The Daily Reckoning
Presents: |
If you missed Part I of Dan Amoss's "sell REITs" column, you can
check out yesterday's issue here. In today's issue,
he makes the bearish case for... Well...it's all in the essay title.
Enjoy...
The Case for Higher Treasury Yields...and Lower
REIT Prices
By Dan Amoss
Jacobus, Pennsylvania
The prospect of rising Treasury yields will pressure REIT valuations.
"Yield instruments" like REITs are priced to yield a "spread" over
Treasuries. So prices of yield instruments usually fall when Treasury
yields rise. I am anticipating this exact scenario.
I'm a bear on Treasury bonds. Prices should go down and yields should go
up as the creditworthiness of the US government deteriorates. Right now,
with the 10-year yield at 3.64%, investors are assuming that the future
direction of inflation and budget deficits will remain under control.
Treasury bond bulls will argue the following points about inflation,
federal deficits, and the existing stock of Treasuries. I've listed the
bullish consensus view in bold type. My responses, listed as the
alternative view, will follow each consensus view:
Consensus view on inflation: "High unemployment and low
manufacturing capacity utilization will keep inflation fears in check.
So those folks expecting inflation fears to push Treasury yields higher
in 2010 are a few years early."
Alternative view: Outside of the panic liquidation conditions of
fall 2008 or the Great Depression, rising prices are hard-wired into the
US economy. If investors panic once again and desperately seek to hold
cash, the Fed can team up with spending addicts in Congress to create
new US dollars in limitless quantities. The past two years have proven
this out.
The issue isn't whether the government can satisfy demands of investors
looking to liquidate assets and hold dollars. As long as Treasury yields
remain low, the government can create limitless amounts of new credit to
satisfy investor demand for default-free government liabilities
(Treasuries and paper money).
Instead, the real risk facing financial markets over the next few years
is whether investors will remain willing to hold cash and Treasuries at
low yields. Cash has no intrinsic value beyond the belief that it can be
exchanged for goods and services. The value of Treasury securities
depends on investors' willingness to hold them, despite the near
certainty that trillions in new Treasury securities will flood the
market over the next decade.
The high unemployment/low capacity utilization argument is theoretical,
antiquated, and based on a fairly closed, manufacturing-oriented
economy. In this theoretical economy, unemployed workers continually bid
the price of their labor lower until supply and demand for labor reach
equilibrium at lower prices.
Today's US labor market does not work that way. The work force is very
specialized. A laid-off automotive engineer is not likely to underbid
the salary of nursing graduates for an open nursing position. Instead,
those who have left the labor pool are collecting unemployment benefits
without contributing to the aggregate supply of goods and services. When
the claims on goods and services grow faster than actual supply, prices
rise. The conditions for hyperinflation arise when an economy's
productivity collapses and supply of government liabilities overwhelms
demand (as confidence in the value of those paper government notes
collapses).
The Federal Reserve promotes the "low capacity utilization" case for low
inflation so it can keep subsidizing the wounded banks with easy money.
But the market could lose confidence in the Fed's theory if the CPI
remains stubbornly high at the same time as unemployment remains high.
The market would express this view by selling off long-duration
Treasuries, which increases yields. If this happens, the Fed will have
to tighten policy to restore the market's confidence in the integrity of
paper dollars. Fed tightening would lead to a reacceleration of the
unwinding of the commercial real estate bubble.
Consensus view on Treasury supply required to fund budget
deficits: "Even though US household savings may absorb just a few
hundred billion in Treasuries in 2010, foreign investors and US banks
will buy enough to keep yields from rising."
Alternative view: Several sources estimate that the US Treasury
must auction roughly $2.5 trillion in new securities in 2010. Some of
the proceeds will retire maturing securities, while the balance will
finance the budget deficit.
The majority of the Treasury securities auctioned in 2009 were bills
with very short maturity. The average interest rate paid on the Treasury
bills auctioned over the past year is roughly 1%. But recently, Treasury
auctions have been weighted more toward the longer maturities. Supply
could overwhelm demand, causing prices to fall and yields at auctions to
rise.
Because banks are choosing to defend their souring bubble-vintage loans,
and writing them off slowly over time, they won't have the capacity in
the "hold to maturity" section of their balance sheets to absorb as many
Treasury securities as the market expects. If banks had flushed most of
their bad loans off their balance sheets in 2009, they would have
capacity to absorb perhaps hundreds of billions in Treasury securities
in 2010. But they didn't.
There is a scenario in which domestic demand for US Treasuries could
exceed new supply in 2010: another stock market meltdown similar to the
one in late 2008. If enough investors flee stocks in a panic and invest
the proceeds into Treasuries, yields could go down.
But considering that the government has committed its balance sheet to
bailing out the financial system, that scenario is unlikely. More likely
is a scenario in which investors question the integrity of the US
balance sheet. The way to do that is to sell Treasuries. This scenario
would be negative for the stock market, likely sparking the next leg of
the secular bear market - a leg that involves several years of the S&P
500 trending gently lower under a rising interest rate environment. But
it wouldn't likely involve a 2008-style panic liquidation of stocks.
Consensus view on the existing stock of Treasuries held by
foreign investors: "Year after year, Treasury bears predict that
foreign appetite for US Treasuries will weaken, but they keep buying.
Foreign central banks will maintain their appetite for Treasuries
because they have to keep their currencies cheap or pegged to the US
dollar."
Alternative view: Foreign investors must be willing to hold
Treasuries at a yield that compensates them for the risk that inflation
and interest rates might go up in the future. If these investors fear
that future inflation, interest rates, and deficits will remain
dangerous, they won't buy more Treasuries until yields rise to higher
levels.
A financial market that's evolved to a state at which it requires a
perpetually growing inflow of new money to remain stable is a Ponzi
scheme. The market for tech stocks in 2000 and real estate in 2006 had
evolved into a Ponzi.
Those who argue that foreign creditors will never sell Treasuries
because it's "not in their best interest" should explain why investors
sold tech stocks or housing when they were in bubbles. Surely, it wasn't
in the best interest of tech bulls to sell. Selling meant prices would
fall, thereby damaging the value of tech stock positions. But they sold
aggressively, because they perceived it to be in their best interests.
The situation of foreign creditors holding an unpayable mountain of debt
of a trading partner is a classic "prisoner's dilemma." A prisoner's
dilemma is a situation in game theory in which two parties might not
cooperate even if cooperation is in their best interest. China and Japan
might both conclude that buying more US Treasuries is not in their best
interest. If they both stop buying at the same time, prices will fall
and yields will rise.
This scenario, by the way, is the reason that the responsible American
public is opposed to Keynesian deficits as far as the eye can see. Just
because Keynesian pro-deficit policies plug a theoretical hole in
"aggregate demand" doesn't mean they are sustainable or wise. The public
understands that Keynesian deficits are unsustainable. The cumulative
effects of these deficits - which are never offset by surpluses during
the good times - ultimately destroy confidence in both the government
bond market and the currency.
When the Japanese government hits the debt wall in the next five years
and Japanese bond yields spiral upward, it will prove the foolishness of
Keynesian policy.
Here is where the existing stock of US Treasuries comes into play. Japan
already owns $750 billion worth of Treasuries. When the Japanese
government hits the debt wall and yields rise, the Bank of Japan will
likely print new yen to fund the government. If so, the value of the yen
could collapse, which would force the Japanese Ministry of Finance to
sell some of its $750 billion in US Treasuries in order to defend its
currency.
It remains to be seen how long the government and the central bank can
keep savers involved in this Ponzi scheme. This scenario - if Japanese
savers abruptly lose confidence in their government's ability to service
its massive debt load with taxes and bond market proceeds - is how Japan
could shift quickly from deflationary conditions to hyperinflation.
Japan is several years ahead of the US in the transformation of its
government bond market into a Ponzi scheme, so we should consider it a
canary in the coal mine.
Aside from Japan, the appetites of two other huge Treasury investors are
waning. The Chinese are rolling their maturing notes and bonds into
buying shorter maturity bills. And the Social Security trust fund is not
far from being in the position where it's a net seller - rather than a
net buyer - of Treasuries. With unemployment stubbornly high, less
payroll taxes are flowing in. With lower payroll tax inflow in 2010, the
trust fund has less of a surplus to invest into Treasuries. When
demographics switch the trust into a deficit position, it will become a
net seller, rather than a buyer, of Treasuries.
All of these factors argue convincingly for rising Treasury yields in
2010 and 2011. The consensus does not seem concerned about these
factors. As of Jan. 20, the FTSE NAREIT Equity REIT Index yields 3.72%.
This is roughly equal to the 3.64% benchmark 10-Year Treasury yield.
Over the past 20 years, the average spread of the NAREIT index over
Treasuries was 100 basis points, or 1%. Removing the influence of the
2005-2007 REIT bubble takes the historical average spread closer to 300
basis points over Treasuries.
So not only are REIT valuations at risk from rising Treasury yields,
they're also at risk from rising spreads over Treasuries. Considering
that REITs are in a prolonged post-bubble environment, it's reasonable
to assume that REIT spreads over Treasuries will rise to 300 basis
points or more. Assuming both factors - rising Treasury yields, a rising
spread of REIT yields over Treasuries - the REIT index could easily fall
50% from current levels.
Regards,
Dan Amoss
for The Daily Reckoning
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And now to Bill who has today's reckoning from Baltimore,
Maryland...
Got money?
You might find it hard to hold onto. Americans with money are caught in
a vise. On the one side is the de-leveraging economy. On the other is
the government.
The depression squeezes everything - asset prices, businesses, earnings.
And it's going to be with us for years - no matter what the papers tell
you. Get ready for a 20% decline in stock prices, says our old friend
Marc Faber. Another analyst puts the current P/E at 22...also implying a
loss of about 20% just to get down to 'normal' levels.
But "this isn't a normal environment," says a senior analyst at Ned
Davis Research.
Well, it's normal - for a depression. When word gets around, you'll see
stocks lose ground. Housing will probably go down in price too.
Meanwhile, over on the other side of the vise, Mr. Obama says he wants
to raise taxes on the rich and on businesses by $1.9 trillion. Let's
see. We'll make some guesstimates. There are about 100 million families
in the US. Of those, about half are net taxpayers. And the top 10% are
said to own half the wealth in the US and already pay 66% of its total
taxes. Looks like they're going to get whacked again. Each of the 'rich'
families will pay nearly $200,000 more in taxes.
The idea is to make the tax system more 'balanced,' says the president,
by taking more money from the people who pay the lion's share of US
taxes...and giving it to people who don't pay anything.
Here's a comment from Chris Edwards of the Cato Institute:
"President Obama has introduced his budget for next year. He proposes
that the government spend $3.83 trillion in fiscal 2011. To put that
number into context, let's take a trip down memory lane.
"Pres. George W. Bush...came into office when annual federal spending
was $1.86 trillion. He proposed to increase spending at a healthy clip,
rising to $2.71 trillion by 2011.
"Bush and his team started blowing their budget almost immediately. They
kept spending more and more - wars, a giant new homeland-security
bureaucracy, a big-government response to Katrina, the prescription-
drug bill, doubling K-12 education spending, big pay raises for federal
workers, financial bailouts, and so on. I can't think of a single crisis
that occurred on President Bush's watch that the Bush-Rove team didn't
have an interventionist and big-spending response to.
"In Bush's last year, FY2009, the government spent $1 trillion more than
the Bush-Rove team had originally planned. It is true that 2009 spending
included $112 billion for the Obama stimulus bill, so let's take that
out. With that adjustment, the Bush-Rove team ended up spending $916
billion more annually by 2009 than they had originally planned. Note
that the wars in Iraq and Afghanistan cost only about one-fifth of that
2009 excess spending amount.
"Then Obama comes into office and turns out to be Bush on steroids with
respect to federal spending. Obama is calling for spending $3.83
trillion in 2011, or $1.1 trillion more than the federal budget nine
years ago had promised. That's a 41 percent forecasting error.
"The lesson from all this is that an administration's promised spending
beyond the first year is meaningless. Obama is proposing a freeze on a
very small part of the budget, for example, but his budget plan next
year will likely find reasons to break that promise. It scares the hell
out of me that federal spending down the road could be 41 percent higher
than even the huge increases projected by Obama..."
We understand the larceny of the tax increases. What we don't understand
is the economics.
The idea of a $3.8 trillion budget is to stimulate the economy. The
Obama team knows as well as we do that this 'recovery' is mostly a
mirage. Without jobs...and housing...you can't expect real growth.
Monetary stimulus has failed. Mr. Bernanke supplies the banks with all
the free money they want. All they do with it is pay themselves bonuses.
What more can Bernanke do? Rates are already at zero; they can't go
lower.
That leaves fiscal stimulus. "Spend more money!" That's what economists
such as Nobel prize winner Paul Krugman, The Financial Times'
lead economist Martin Wolf, and Japan expert Richard Koo are whispering
in Obama's ear. Spending supposedly boosts sales and creates jobs.
But if you're just taking money from one pocket and putting it another,
what's the point? There is no net increase in spending power. Still,
economists argue that the rich don't spend their money; they save it!
And we know what an awful thing saving is...
Taking money from 'the rich' actually retards a real economic
renaissance. The rich are the ones who consume the most...because they
have the most to spend. More importantly, they're the ones who fund the
small businesses that do the hiring. Banks won't take a chance. It's the
relatives...and 'the rich' themselves...who put their money on the line.
Either someone forgot to explain this to the Obama administration or
they just don't care. In Washington, politics trumps economics every
time...
And now, both politics and economics are putting pressure on Americans
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And more thoughts...
Here's another mystery: Homeowner defaults. Not that there are so
many...the mystery is why there are so few...
In Nevada, for example. Two out of three homeowners are
underwater...which is hard to do in the desert. Some of them owe
hundreds of thousands of dollars on something that doesn't exist anymore
- the equity on their houses. Still, most of them continue making
mortgage payments. What gives?
It's a case of "asymmetrical ethics," says The New York Times.
Lenders don't hesitate a minute to maximize their earnings - using every
tool available to them and every trick in the book (including some
tricks that have never been published). They default whenever it suits
them.
But homeowners? They plod along. Maybe they think their house will come
back in price. Maybe they think they'll suffer some awful penalty if
they default. Maybe they are just too proud and too honest to take
advantage of the non-recourse mortgage provisions. So, they keep paying.
But for how long? Mortgage rates are based upon past behavior. In the
past, people regarded mortgage payments as an inescapable, moral
obligation. You paid as long as you were able.
It won't be long before the ethics of Wall Street catch on all across
the country. Gaming the mortgage system will become as common as signing
up for food stamps. When people see that house prices won't go back
up...and when they see their neighbors shedding hundreds of thousands of
dollars' worth of mortgage debt - and getting away with it - they won't
be far behind.
"You've been out of the country for a long time. Maybe you notice it.
Most people don't."
The subject was hamburger. At a hamburger joint in Rockville, Maryland,
the server had asked:
"How would you like that burger cooked?"
"Medium rare," we replied.
"I'm sorry. We don't do medium rare," was the reply.
Why doesn't a restaurant cook a hamburger the way the customer wants it
cooked?
Recently, in Baltimore, we ran into the same sort of thing. At the
Peabody Court hotel, we asked the desk clerk if he could have someone
pick up our laundry. We had left it neatly on the bed, with a laundry
slip all filled out.
"You have to bring it down here," was his reply.
"What?"
"You have to bring it down yourself."
"What? Isn't this a hotel? Aren't you in the hospitality business?"
Our protests were useless. They wouldn't pick up the laundry because
they had a policy against it. The policy was designed to protect them
against customers who tried to take advantage of them by claiming
laundry had not been returned. Now, a guest has to bring his dirty
laundry to the front desk and have it inspected!
The restaurant had similarly taken measures to protect itself from
customers who might get sick from uncooked beef. As at the hotel, the
precautions are for the benefit of the business, not the customer.
"Oh...and I heard something on the radio..." we continued with our
conversation with a colleague. "There is a proposal in Maryland to make
it a criminal offense to smoke in a car in which a child under the age
of three is riding. Already, you can't smoke in bars or restaurants.
There doesn't seem to be any limit to the improvements a legislature can
make, does there?"
"Yes. And the most amazing thing is that people will go along with
anything. There is no resistance. Nobody thinks anymore, they just
follow silly rules and procedures. I was just on a trip outside the US
with a group of older people. We traveled around other countries with no
problem. But coming back to the US was a hassle. They carefully searched
all these old people...as if they really thought these folks posed a
threat to homeland security.
"This war against terror probably conditioned Americans not to question
authority. It's been going on for 9 years now. As far as I can remember
there were only two incidents in all that time...and they were almost
comic. One guy set his underwear on fire...the other lit his shoes..."
Regards,
Bill Bonner,
for The Daily Reckoning
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