The focus on US deficits was given a big boost by the news that Moodys downgraded the debt of England. Who would have thought that England, once the financial center of the world and still one of the largest financial centers, would have come to this state? Even more surprising to many is the increasing perception of the possibility that US government debt will be downgraded from the world’s most secure to a lesser status. The news of Britain’s downgrade also caused a sharp fall in the price of US treasuries, because people judged that what happened in England could happen here. Bill Gross of PIMCO (the largest bond company in the world) said that this is not unthinkable (which means it is thinkable).

I recently posted an article on the negative for Britain of the dominance of the financial sector there, arguing that the parallels with the US are all too great. One of the parallels is the massive deficit that both countries are incurring in trying to keep their financial sectors and the economy afloat in a world that imploded as a consequence of financial excesses.

John Mauldin has an insightful, very detailed review of the magnitudes of coming US deficits, their likely consequence for interest rates and bond prices, and of his own gloomy thoughts on the implications for the future non-prosperity in the US. Below are some selected quotes with a link to the full article.

John Mauldin at frontlinethoughts.com, 5/23/2009

A Trillion Dollars as Far as the Eye Can See

As of this week, total US debt is $11.3 trillion and rising rapidly. The Obama Administration projects that to rise another $1.85 trillion in 2009 (13% of GDP) and yet another $1.4 trillion in 2010. The Congressional Budget Office projects almost $10 trillion in additional debt from 2010 through 2019. Just last January the 2009 deficit was estimated at "only" $1.2 trillion. Things have gone downhill fast. …

The Global Recession Gets Worse

Let’s take a quick trip around the world. In the first quarter, the German economy fell by 14%, Japan by 15%, Mexico by 21%, and England was down almost 8%.

Global trade is simply collapsing. The chart below is the ugliest it has ever been. Chinese exports are down 41%, Japanese exports down 38%, Germany’s down by 32%, and so on. (chart courtesy of www.variantperception.com )

…

European banks are in far worse shape than their US counterparts. That is because they utilize far more leverage, on an average about 30 times leverage. How can that be, in what is supposed to be a conservative industry?

"European banks were only restricted on the basis of risk-weighted assets, unlike the US where it is the total leverage ratio that matters, so most European banks bought assets that were rated by Moody’s and S&P, who couldn’t rate their way out of a paper bag, and for anything that wasn’t highly rated, they bought credit default swaps or guarantees from AIG and MBIA. Because of that European banks were able to lever up a lot more than their US counterparties. Given the much higher leverage levels and general worsening of collateral values, we think that all the shoes in Europe have not dropped."

European banks have assets of about 330% of their GDP, compared to US banking assets, which are about 50%. They have over $700 billion in loans to Asian businesses (which are watching their exports collapse) and $1.3 trillion in loans to Eastern Europe, which is in a very serious recession, and so many of those loans are simply not going to be worth anything. Simply put, there is going to be a need for massive amounts of money to bail out European banks, or we’ll watch their economies simply implode. …

Governments around the world are responding to the global recession by running massive deficits. In addition to the US, the UK, Japan, Russia, Spain, and Ireland are all running deficits of over 10%.

And, as in the case of the US, these are not going to be one-time deficits. The IMF predicts that England will shrink again next year and the recovery in the US will be modest at best. The US economy is expected to grow by 0.2% (far from the optimistic projections of various US government agencies), the 16-nation eurozone will eke out a modest gain of 0.1%, and the Group of Seven (G7) leading industrial economies will, as a whole, only grow by 0.2 percent. They project that Japan’s economy will stagnate next year.

Where Will the Money Come From?

And now let’s look at what is bumping in my worry closet. The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year. The Fed can monetize a trillion. Maybe. Look at the yield curve on US government debt below (Bloomberg). US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn’t do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

The world is deleveraging. Debt is being drawn down. Securitization of various types of debt has seriously slowed. Banks are cutting back on lending. Home prices are dropping all over the world. Commercial real estate is rolling over, and banks all over the world are exposed. "Recession turns malls into ghost towns" is the headline in today’s Wall Street Journal. Personal savings are rising and retail sales are flat to down. Unemployment is rising.

All this should be massively deflationary. Interest rates should be falling or at least not rising. But a funny thing is happening. In the past two months, the yield on the ten-year bond has risen by 1%. It has moved 0.38% or almost "4 big handles" in just two weeks. Look at the chart below. What is happening?

According to Merrill Lynch, the size of the world bond market is estimated to be approximately $67 trillion, with the shares of US, Euroland, and Japanese securities each representing less than 50 percent of this total. (PIMCO)

England has been put on negative watch for its debt rating. Bill Gross said yesterday that it is not unthinkable that the US could lose its AAA rating. I think the bond market is looking at the mountain of debt that will have to be somehow sold and wondering where such a colossal sum will come from. Where do you find $10 trillion in the next ten years for US debt?

And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let’s be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less. It also assumes massive tax increases from carbon credits.

…

Long before we get to 2015, let alone 2019, I think the bond markets will have called a halt to $1 trillion deficits. There will be a real crisis. The deficits will not be funded at anywhere close to an interest rate that will not break the budget. Taxes will get raised beyond what they were in the Clinton years. And Obama’s budget makes some very optimistic judgments about how much will be saved in medical costs, as if no one has tried to rein in medical costs before. The crisis may come much sooner if his universal health-care bill is passed as proposed without offsetting cuts somewhere else.

Watch the bond market. Rates should be going down, not up. The bond market is telling us the deficit simply can’t be financed down the road. Now, maybe a few cool heads in the Democratic Party will prevail in the US Senate and the deficits will be brought under control. (The Republicans have so far seemed as clueless as they are impotent.) We could (theoretically) run $400 billion deficits for a very long time, as GDP would be growing somewhat faster.

It would be best to run budget surpluses, but the game does not end if there are reasonable deficits. It ends with deficits that cannot be funded except by monetization. And that will tank the dollar, except against all the other countries that are monetizing their debt.

I am increasingly inclined to think that as the world comes out of its current malaise – and it will – US investors should think more globally with their investment portfolios. That is something we will explore over the coming year. But that’s enough for today.

Full Article

George Soros was an early and avid supporter of Barack Obama, so it’s probably no surprise he gives the President high marks for his handling of international affairs, the stimulus package, the budget (the famed financier calls it "very courageous") and for "stabilizing" the financial crisis.

But President Obama "lost a great opportunity" by not taking a more radical approach in dealing with the banks, Soros says. "There’s too much continuity with the bumbling and mishandling by the previous administration. Not enough discontinuity."

Specifically, Soros wanted Obama to "come out of the gate with a well considered plan" to recapitalize the banks, rather than continuing with the TARP and related bailouts. But the President may have been hampered by his desire to create consensus, Soros says. "The nature of far from equilibrium situations is that public understanding is always lagging behind events. If you’re guided by desire to have consensus, you’ll always be a little bit slow."

Mr. Soros focuses less than I on the inequity of taxpayers bailing out bank investors. His concern is more on the ineffectiveness of propping up Zombie banks, instead of forcing recapitalization. He is not, however, any happier than I at the lost opportunity.

Below are links to all of the interviews, with the last in the series listed first:

 

• Americans Were "Living in a Fool’s Paradise" That’s Gone Forever, Soros Says
• Soros: Obama "Lost a Great Opportunity" to Fix the Banks
• Soros Says Fed in a Bind: Beware Stagflation, Bursting of Bond Bubble
• Soros: Dollar’s Strength a Measure of System’s "Sickness"; Euro Will Remain Viable
• Soros: "Danger of Collapse Has Passed," But Stock Rally Not Sustainable
• Soros "Very Concerned" About Global Unrest, But Sees Positive Signs in Russia

Brad Stetser, a thoughtful economist with the Council on Foreign Relation, is a specialist on international capital flows. He has traced the recent movements of funds in and out of dollars. It paints an interesting picture. What it says for the future of the dollar is, as usual, open to dispute, as the comments on his article show.

How a US financial crises rebounded to benefit the dollar: three pictures

Posted on Wednesday, March 4th, 2009

By bsetser

How exactly can a financial crisis that started in the US — and that has hit the US hard — be good for the dollar?

Part of it is that other countries are now in worse shape that the US; what started as a US crisis turned into a global crisis. Part of it is that a fall in the price of oil is good for the US (lower oil import bill) and seemingly good for the dollar. And part of it is that — judging from the TIC data — Americans are selling their foreign investments in “risky” assets faster than foreigners are selling their investments in risky US assets.

The huge surge in demand for T-bills from central banks and private investors alike hasn’t hurt either.

The evidence? To start, there is no real sign that private demand for US corporate bonds has picked up. There was a blip up in the December TIC data. But a rolling 3m sum — a measure that smooths out a bit of the monthly volatility — suggests that overall demand for US corporate bonds remains subdued.

Moreover, what matters for the dollar is foreign demand for US assets relative to US demand for foreign assets. Foreign demand for US corporate bonds and equities remains very weak. Foreigners aren’t therefore providing the flows needed to sustain the dollar (and the US current account deficit) by buying risky US assets. But that doesn’t matter so long as Americans are selling their foreign portfolio. Over the last three months of data (October to December) net sales [red line] have generated a flow of close to $100 billion dollars.

And then there is global demand for treasury bills. That soared in the crisis. Call it a dollar shortage among private investors. Or call it a flight by central banks away from anything that hints of credit risk, as Agency sales offset some of the surge in central bank purchases of Treasury bills. But the graph still speaks for itself.

The real question is how long this pattern can persist. The last TIC data point comes from December — and we are now in March, so the pattern could have changed over the past couple of months. The dollar’s ongoing strength though suggests that there is an underlying supporting flow, and the market’s ongoing distress suggest it hasn’t come from a surge in foreign demand for risky US assets. Setting aside ongoing demand for Treasuries from central banks (the Fed’s custodial holdings have continued to rise) and dollar liquidity-starved investors globally, my guess is that global capital flows are still contracting. They just seem to be contracting in a dollar positive way …

What stands out for me is that foreign purchases of T-bills have been the dominant inflow factor. This seems very much to reflect the "flight to quality." So long as the global economic crisis continues to generate fear and uncertainty, this inflow may well continue. However, the last chart shows that this is an abnormal level of inflow, and at some point it will diminish and may well reverse — with corresponding effects on the dollar.

To say that he has switched from being a stock market bear to being a bull would be inaccurate, but it is fair to say that he now believes the long-term upside potentials outweigh the downside risks. Where he is bearish is on the dollar and U.S. Treasuries, both of which he continues to believe will be long-term losers as a consequence of the unrestrained monetary policies of the Federal Reserve. Like all intelligent prognosticators,  he heavily qualifies his thoughts and acknowledges that they may easily wrong in the short run. Nevertheless, his views are based on careful weighing of evidence and long experience.   

Be aware that the excerpts reprinted here give only a spare glimpse of the 16 pages of his newsletter. Those who see the wisdom in the excerpts and who manage their own investments will find his newsletter a small price for big insight.

Excerpts from his current newsletter, available by subscription, are reprinted by permission. References to figures in his newsletter have been omitted without ellipses in the excerpts.

In Gold I Trust! But With Some Reservations…..
Marc Faber
March 1, 2009
…

To put it bluntly, the global economy is in deep trouble! An
unprecedented wealth contraction post Second World War has occurred,
and industrial production as well as capacity utilization rates, new orders,
exports, and incomes are contracting at an unprecedented rate.Now, I am not trying to downplay the economic downturn. But since I
travel extensively all over the world I am actually astonished that, despite
horrible economic statistics and despite business being down everywhere
(however, exceptions exist such as sales of computer games, guns,
bullets, private label brands, gold coins, safes, and of course – as can be
expected – the expansion of the government), economic activity is still at
a relatively high level. Maybe people live in denial and do not yet
recognize how much more the economy is likely to deteriorate or they
take a fatalistic view by thinking about how much money they lost in
asset markets and, therefore, decide to have a good time either traveling
on holidays or going out at night. But if this is a depression, then I have to
say that it is a depression at a relatively high level of prosperity.
Personally, I think the global economy will deteriorate far more and that
we have, so far, only seen the appetizer of the great economic
contraction.  [Underline added. Bold in original.]

My take is that global non-government sector GDP has already
contracted by about 10% from its 2007 peak and that it will contract by
another 10% to 20% in real terms. I am aware that official statistics by
governments do not support this observation, but asset markets seem to
confirm the magnitude of the economic contraction…

[As] as far as I am concerned, the CRB [commodity] Index suggests that
we are in for a terrific economic slump. This index is in nominal terms
around 10% above the 1999 and 2001 lows but in real terms below these
lows (I should add that the 1999 and 2001 lows occurred after a 20 years
bear market – see Figure 3). The point is simply that some asset markets
may already have discounted much of the coming slump…

I am fully aware that the majority
of investors now feel that there are no good news on the horizon and that,
therefore, another sell- off to new lows is in the cards. However, the
renewed weakness in major indices may have obscured the fact that some
stocks and even indices had major rallies since the November lows…

I have sympathy with Alan Newman, the editor of Cross
Currents (www.cross-currents.net), who wrote a few days ago that, “our
technical work reveals a sold out stock market. Those looking for a
capitulation phase as a catalyst to a reversal are not likely to get
one. There can’t be a capitulation when investors are already out of the
market…

Now, I have no idea whether by year-end 2009 stock markets will be
higher than they are today or even lower. However, I want our readers to
recall well what sentiment was like in the summer and fall of 2007 when
equities peaked out. Just about everybody was widely optimistic about the
global economy, the BRICS, synchronized growth forever, and
decoupling of emerging economies in case of a US recession. In addition,
nobody forecasted a 50% drop in global equity prices (except some
pundits who had been forecasting this event since 1987). Now, 15 months
after the October 2007 peak and with stock markets down 50% or more
from their highs in a very brief period of time, everybody is extremely
negative about “everything.”…

But the point is this: The 2007 – 2009 US bear market has been
unprecedented post Second World War in terms of its downside
momentum and its brevity.  Not surprisingly
has the stock market’s extreme collapse – against all expectation – brought
about bearish sentiment extremes, which in the past were usually
associated with temporary rebounds or often with major market lows…

Still, I wish to clarify my position very clearly: I am extremely
negative about the global economy and financial markets in real terms. I
doubt we shall see global peak economic activity and growth such as we
had between 2004 and 2007 for a very long time… [Emphasis in original]

[The} more I think about current condition, the more depressed I become.
Amidst a global slump I believe that we are moving toward high inflation
(a further depreciation in paper money’s purchasing power), evil fascism,
and vicious military confrontations. In theory, gold would be the best
asset to own in this condition… However,I have some reservations…

For one, gold has already experienced a powerful bull market between
2001 and the present. As a result, gold has become relatively expensive
compared to equities and the CRB Index. I am not suggesting that this
outperformance of gold compared to other commodities and equities
cannot continue. In fact, I believe that in time one Dow Jones will buy
less than one ounce of gold. However, near term, gold would seem to be
both over-bought against the Dow Jones and the CRB Index.

…

I, therefore, expect that at some point the Fed’s money printing will be
effective in lifting real estate and equity prices, but at the cost of
weakening government bonds and the US dollar…

All I am suggesting is that investors should be prepared or begin to
diversify their currency exposure for the day US “money printing” will
lift asset prices and weaken the US dollar.

© Copyright 2009 by Marc Faber Limited – All rights reserved. Reprinted by permission.