It's double bonus day! Enjoy.
Regarding Defaults and Debt Ceilings…
It would be an understatement to say that much of the media is focused on the debt ceiling and the showdown on Capitol Hill to get a deal worked out so both sides will go for raising the debt ceiling. “To cut (entitlements), or not to cut”, “to raise (taxes), or not to raise”…that is the question…
Everyone is concerned (including the chairman of The Fed and the Secretary of the Treasury) that not raising the debt ceiling would most certainly cause the U.S. Treasury to default on paying its debt obligations and spark another world-wide collapse in the markets. While a market collapse isn’t outside the realm of possibilities, it is the long-term implication (default or not) that I’d like to look at for a moment…
To aid this post, I’m putting up excerpts from an article from Yahoo! Finance from March 8th. The information is just as relevant today as it was four months ago. My comments will follow.
Any emphasis in the article is my own.
"No Way Out" of Debt Trap, Gross SaysThere are two things we can glean from the above:
Debt, debt and more mounting debt is plaguing countries around the globe.
In the U.S., states across the country face a collective $125 billion shortfall for fiscal 2012, while Congress is facing a budget gap nearly 10 times that size.
PIMCO founder Bill Gross -- one of the world's largest mutual funds managers, who focuses mostly on bonds -- has previously said that if the United States were a corporation, no one in their right mind would lend us money. For the last decade, we’ve been “relying on the kindness of strangers” to help cover our debts…
By “strangers” he is referring to our foreign counterparts, like China for example. Basically, for years Americans have spent their hard-earned dollars on less-expensive Chinese made goods. With great gratitude, China turned around and used all those dollars to buy up U.S. Treasuries and other dollar-denominated assets.
But now after years of reckless spending, America’s debt level is nearing a breaking point and can no longer rely on foreign capital as a last resort. “When a country reaches a certain debt level, confidence in that country’s ability to repay that debt becomes jeopardized,” says Gross, citing the work of Ken Rogoff and Carmen Reinhart in This Time Is Different.
The budget crisis situation unfolding - at the state and federal government level - does not bode well for working men and women in this country. There are really only two choices, says Gross. And, neither favors your pocketbook:
Option #1 – Keep spending and do nothing
Option #2 – Balance our budgets by cutting entitlements
House Republicans ran and won on a platform to cut billions from the budget. But for President Obama and Congressional Democrats, those cuts go way too far at a time when the country is still struggling to recover from the worst recession since the Great Depression. Goldman Sachs and Bill Gross agree and have warned that cutting too much could stifle growth.
Meanwhile, neither side has gotten serious about reforming entitlement programs like Social Security and Medicare, which account for more than a third of Uncle Sam's budget.
If the country cannot come to grips and cut back on entitlement programs, U.S. debt will continue to grow and governments around the world will lose faith in the U.S. dollar. Foreign goods would become more expensive, says Gross, while our standard of living would drop.
Under the second option, if entitlement programs are cut, many Americans would naturally have to learn to live on less and take a hit to their standard of living.
“There is really no way out of this trap and this conundrum at this point,” says Gross. From an investment perspective his advice is to stay clear of “bonds in dollar denominated terms” and to be “wary of higher interest rates going forward.”
- The guy who runs one of the world’s largest mutual fund companies (managing over $1 Trillion in assets), who managed the world’s largest mutual fund (PIMCO Total Return Fund), and who has made a living (the majority of which) has been in creating and managing BOND FUNDS is saying “stay clear of bonds in dollar terms” (A.K.A., U.S. Treasuries) and has done so with PIMCO!!!!
This is serious stuff and has huge investment implications…why?
For starters, if you don’t know anything about bonds, read this post from a few months back to understand how the valuation of bonds is directly linked to the movement of interest rates. In short, as interest rates go up – which they will (as we are sitting at historically low interest rates courtesy of the Federal Reserve’s decisions) – the value (price) of those investments will decline. So anyone holding those bonds (like PIMCO which held a ton of U.S. Treasuries), would see a loss on their investment.
Additionally, normal investment advice goes something like this: “the older you get (and need more fixed income) the less risky your investments should be – so as you get older, begin changing your asset allocation where you hold more bonds than stocks.” Many blended financial products hold U.S. Treasuries (not all, but many). Target date funds are one example of this common investment advice put into practice and a financial product where the investment company automatically changes the fund investment mix for you the older you get (see chart below for illustration of the changing mix over time - click to enlarge). This is important to realize as such an investment will most likely take a hit in an environment of rising interest rates. - Lastly, and more importantly, Bill Gross is contemplating the fact that the U.S. may default on its promise to pay holders of our debt. While this may seem far-fetched to some, he pointed out in the above article (and which I tried to highlight with overly gratuitous large font) that it is the confidence level of those buying our debt that is important. Whether or not we actually default is beside the point. If investors decide it’s not a good investment anymore then that changes the demand for our debt and we may no longer be able to find buyers of our debt to finance our government’s spending habit – this is a long-term problem. This is what Mr. Gross sees if things don’t change. The confidence level is the main driver, not an actual default. Even if we skirt default this time around, our financial house is a mess as a country.
Standard and Poor's (rating agency) warned just the other day there is a 50% chance it will lower the U.S. government's AAA credit rating by one or more levels within three months - even if Congress raises the debt limit in time to avert a default (don’t look now, but the U.S. has already been downgraded by smaller and lesser know rating agencies: Weiss Ratings – from C to C-; Egan-Jones – AAA to AA+; and Dagong (Beijing) – AA to A+). Not good news. Our friendly “strangers” that are financing our debt (30% of our debt mind you – see chart below - click to enlarge) may not find our debt so attractive anymore if we are no longer seen as a sound investment with a AAA rating. If they disappear as investors of our debt, how will we be able to pay our credit card bill as a nation?
Why You Should Care About the Budget and the National Debt…
All the national debt talk can seem so nebulous. After all, talking about trillions of dollars is difficult to conceptualize.
If you see the ticker at the top of the page, it breaks down our debt situation. Over $14.3 trillion in debt. That equates to over $46,000 per citizen. How about this…Our spending rate is roughly $58,000 per second. Truly astounding.
So why should you care? If unchecked, those figures have the potential to swell and affect us in very BIG ways.
Here are the BIG ways – I’ll unpack each below:
1. Interest rates will rise
2. Slower growing economy
3. Higher taxes
4. Higher inflation
Interest rates
Historically low interest rates for the past few years have helped the federal government out in big ways – they are able to finance their excessive spending by selling U.S. Treasuries at very low rates, thus having to pay out less money in payments. Foreign investors fund more than 30% of our debt. While those entities will probably continue to buy our debt if they have confidence in our ability to make good on payments, they are not likely to want to keep buying it with such low rates of return. So three possibilities exist – based on a demand for higher rates, we either 1) will have to pay higher rates (FYI – that means that even just a 1% rise in interest rates equals approximately $150 billion in extra debt payments – ouch!), 2) lower the value of the dollar (debase the currency), or 3) do a combination of both.
Additionally, interest rates on U.S. Treasury bonds are a benchmark for consumer loans (mortgages, car loans, credit card rates, and student loans). When interest rates go up for Treasuries, so do rates for consumers products…I guarantee many people inside the U.S. will feel that.
Slower growing economy
This is pretty straight forward - if interest rates go up, then a larger portion of the government’s budget has to go towards interest payments. This means less money is available for economically “stimulating” activities and government spending – building roads, buying weapons, providing tax incentives, providing benefits, etc. Less money in the spending/consuming machine results in a slowing or retracting economy.
Higher taxes
As I’ve said before in a previous post, our government has a spending problem because we love entitlements and a full service government. Unfortunately, we aren’t willing to pay for it. It is ideal if you can cut spending first before raising taxes, but desperate times call for desperate measures. At some point, the government is going to do something to gain more revenue. Exhibit A: In the near term, the Bush era tax cuts expire in 2012. That’ll be a big deal and based on how Congress treats the issue (extending the cuts or letting them expire) we’ll see where they stand: cut spending or raise taxes.
Higher inflation
Here’s where it gets a little more complex, so I’ll try and make it simple.
Our government borrows money (sells U.S. Treasury bonds) on relatively short terms (2-year, 5-year, 10-year, etc.). And, just like many corporations, it borrows new money every few years (issues new debt) to pay off the old debt – a kind of “never ending re-financing” loop, if you will (yes, it sounds strange, but such are the tactics of a government that pays out more than it takes in – you have to keep the Ponzi scheme going somehow).
However, if investor confidence wanes regarding U.S. bonds and investors head for the door (selling existing U.S. bonds or simply not buying them), we have a problem: the short-term debt can no longer be rolled over (because no one wants to buy it). What happens then? The Fed will have to print more money to buy the maturing debt – thus bringing inflation to our doorstep.
Inflation hurts everyone, simply put. Higher prices on goods and services, higher rates on any financial instrument you may use to borrow with (mortgages, car loans, student loans, etc.), etc.
The “wealth effect” created in the stock market by inflation (where people “feel” wealthier because their stock investments are going up) is only short lived as real pocketbooks feels the pinch of higher prices on everything in the real world.
Those who are really hurt are those on fixed incomes (the elderly and disabled) as their dollars don’t stretch as far buying the same goods and services whose prices are now going up.
Bottom line:
So, (while painfully obvious now) having a growing national debt hurts everyone. You should care.
“Now you know. And knowing is half the battle.”
(Quote courtesy of G.I. Joe. For a little G.I. Joe cartoon nostalgia and a message about telling the truth, click here).
