Where Will We Get the Cash?

Last week’s turbulence shined a harsh spotlight on the stock market. Appropriately so, if that’s where your investments are. But in the hubbub many investors are missing the deeper and far more urgent bond market issues.

We already knew interest rates were rising. Recent data suggests they could rise significantly more than many expected just a few weeks ago. If so, that will be a big problem for bonds, stocks, and many other assets – not to mention taxpayers who will bear the cost of swelling government debt, consumers who may face inflation, and everybody who will be hurt by a recession.

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The combination of a falling stock market and rising interest rates is historically and statistically rare. Normally, when the stock market goes through a correction, interest rates fall. Looking back through history, we see that 1987 and 1994, two years I have been writing about in connection with 2018, were the other unusual years.

I’ve been relatively optimistic on the economy this year, and I still think the year can end well. But given recent events, the path is more challenging now – and the odds of a rough 2019 are growing.
Burn Rate

Sudden market moves usually have many contributing factors, but they still need a trigger. Typically, it’s some new piece of information that wasn’t already reflected in prices. What did we learn just ahead of the drop on February 2 and then the bigger one on February 5?

I still think the key factor was the Friday unemployment report, which showed wage growth of 2.9%. It is been a long time since we’ve approached 3% wage growth. The markets, probably rightly, interpreted this as a sign that the Fed will turn more hawkish if that trend continues. The Fed’s going into inflation-fighting mode is not bullish for the market. From a recent Congressional Budget Office (CBO) statement:

Next, because the tax legislation reduced individual income taxes for most taxpayers, the Internal Revenue Service released new income tax withholding tables for employers to use beginning no later than the middle of February 2018. As a result of those changes, CBO now estimates that, starting in February, withheld amounts of individual income taxes will be roughly $10 billion to $15 billion per month less than anticipated before the new law was enacted. Consequently, withheld receipts are expected to be less than the amounts paid in the comparable period last year. In addition, the government ran a deficit of $23 billion in December, and it normally runs a deficit in the second quarter of the fiscal year. 

We knew part of this. The tax bill President Trump signed in December was passed under reconciliation rules that allowed the reduction of revenue by $1.5 trillion over 10 years. That works out to $12.5 billion per month, roughly the amount CBO says tax withholding will drop. Economic growth is supposed to offset this. I think it will to some extent, but not enough and, more importantly, not soon enough.

Also on Friday, in a separate report, the Treasury Department estimated that it will borrow $955 billion in FY 2018. That estimate is based on input from a group of private banks that advise the Treasury. If the amount is correct (and it may not be), it will represent an 84% increase over the $519 billion Treasury borrowed for FY 2017.
This huge increase is clearly not taking us in the right direction, and it’s more than can be accounted for by lower tax revenues. Nor is it a one-time blip. The same report forecasts borrowing of $1.083T in FY 2019 and $1.128T in FY 2020.

The budget that has now been passed by the Senate and is likely to pass the House and be sent to Trump to be signed will add another $300 billion to the deficit over just the next two years. We are going to exceed $1.2 trillion in average debt for the next three years, and that’s just the on-balance-sheet deficit.

What’s the problem, you ask?

The answer will get us into some little-examined and perhaps arcane fiscal policy issues. They are nevertheless important. In short, the budget deficit and the amount of government borrowing (for the year) are two different things. The official deficit increasingly understates the problem… and I think markets are starting to realize that.

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Off-Budget Games

Politicians like to talk about managing the federal budget the way you manage a family budget. This rhetoric makes for good sound bites but ignores an obvious reality: The federal government isn’t like your family. It has exponentially greater powers and responsibilities and is a sprawling behemoth to boot. The same budgetary principles don’t always apply.

For one, you can’t set your home budget and then add additional expenses without changing your budget parameters. The government can do so, and it does. These are the so-called “off-budget expenditures” you may have heard about. They don’t affect the official deficit that is discussed in the press. They do affect the amount of cash the government needs. Where does it get that cash? It borrows it by issuing Treasury paper.

Off-budget expenditures pay for a variety of programs: Social Security, the US Postal Service, and Fannie Mae and Freddie Mac are among the more familiar ones. But the category also includes things like disaster relief spending, some military spending, and unfunded liabilities that turn into actual costs. Federal student loan guarantees sometimes force the government to disburse cash. That’s an off-budget outlay.

Off-budget outlays have risen in part because they include Social Security benefits, and the Baby Boomer generation is retiring. But the other categories mentioned above have grown as well, and they are increasingly problematic.

The Treasury Department has the unwelcome job of juggling the government’s cash flows to pay the people and businesses Congress has decided should be paid. When there isn’t enough tax revenue, Treasury must borrow to meet the difference. Any unforeseen decrease in tax revenue or increase in expenses can force it to borrow more. This activity has nothing to do with the formal “budget” even when we have one, and we currently don’t.

Do you remember a headline mentioning annual trillion-dollar increases in the US debt during the last eight years of the Obama administration? I didn’t think so.

The problem has been papered over by off-budget receipts, mainly Social Security taxes, that give the US Treasury more cash it can disburse. But eventually the benefits those taxes represent come due. Then outlays go up, but revenue may not.
We are rapidly reaching that point. Look at this table, which I found here and excerpted:

National Debt by Year:  Compared to Nominal GDP and Major Events

You will notice that there are many years during which the US debt rose by more than $1 trillion. Note that 2015 saw an increase of $1.4 trillion, while the on-budget deficit that year was “just” $439 billion.

Admittedly, 2015 was an outlier, but lately it hasn’t been much of one. Look at this chart of the on-budget deficit for the last 10 years. Comparing to the above table, you can see that off-budget deficits have been running more than $500 billion recently. Some years not so much, but the general trend has been from the lower left to the upper right.

But wait, there’s more.

0% Financing Ends

Since 2008 the Federal Reserve has greatly simplified Treasury’s cash management task. It has kept short-term rates ultra-low, allowing the Treasury to borrow tons of cash with minimal financing costs. The Fed also bought Treasury bonds directly as part of its quantitative easing programs. Since the Fed sends most of the interest it receives right back to the Treasury, those bond purchases amounted to almost interest-free financing. The average interest paid on the US debt has been reduced to less than 2%, largely because Treasury has loaded up on short-term debt in order to reduce the interest-rate costs that must be allocated to the budget deficit each year.
So rather than focusing on long-term debt with the 30-year at an all-time low, Treasury has been selling short-term bills and notes. That’s good cash management in the short run and very shortsighted in the long run.

Both those factors are now changing. The Fed is actively raising short-term interest rates while also reducing its Treasury bond purchases. The FOMC’s December “dot plot” suggests that rates will rise to 2.25% by the end of this year and to 2.75% in the longer term. This increase will raise Treasury’s interest costs considerably. And the interest must itself be financed, so that requirement will drive borrowing needs yet higher. Do you think the chances are good that the Treasury will be able to finance its debt at 2% in 2019? Me neither. And with $20 trillion total debt, even a 0.5% interest rate increase will have an impact on the overall budget deficit.


On the balance sheet unwind, here again is a chart I shared last week:

The important point here is that the Federal Reserve balance sheet reductions are just now getting started. The pace will quicken. In January the Fed’s Treasury bond assets dropped by $18 billion. The shrinkage will vary by month, but the combined total Treasury and mortgage bond balance is set to fall $420 billion this year and another $600 billion in 2019. The number will continue to fall at that pace until either the balance sheet reaches zero or the Fed decides to stop.

This path would be fine if the Treasury’s cash needs were likewise falling. Instead, they are rising. That $1 trillion that the Fed is going to sell back to the market will cost the Treasury a minimum of 2% and probably closer to 2.5%. That increases the deficit by $20–$25 billion a year.

So let’s add it up. The federal deficit will be north of $1.1 trillion. Let’s assume the off-budget deficit actually drops to $400 billion and that the Federal Reserve is going to want to sell $460 billion into the market. (Note: some of that will be mortgages, and the rest will be US bonds and bills.)

Simple arithmetic suggests that we will need to find about $2 trillion in additional funding to buy government debt in 2018. And candidly, that may be an optimistic projection.

Which brings us to this letter’s titular question: Where will we get the cash?

Lender Search

In theory, it should not be a problem for the US government to borrow all the cash it needs. Occasional political antics aside, we are the world’s best credit risk. No one worries that they won’t get their T-bond principal back. The entire global financial system depends on that rock-solid guarantee.

So, the question is less whether Treasury can repay than whether potential borrowers are healthy enough to supply our needs or might see better alternatives. This question is important because Treasury is losing the Federal Reserve as a primary funding source. Who can take its place? There are several candidates. Unfortunately, each has barriers that may reduce their buying interest.

American savers and investors are prospects if they have money to lend.
Unfortunately, the number who do is not growing. It may grow if unemployment stays low and wage growth accelerates, but the Baby Boomers are transitioning from savings mode to spending mode, so they won’t help much.

US pension plans and other institutions that need to fund future obligations are natural Treasury buyers, too. Higher rates might entice back some buyers who have moved into corporate or other long-term bonds in the last decade. Then again, high enough rates will entice anyone back, but those higher rates come with a cost.
Specifically, each 1% higher is $10 million per trillion dollars of debt issued. On our $22 trillion in total US debt (by the end of the year, give or take a few billion), that will eventually be about $220 billion in interest as rates go up and the debt has to be rolled over. That’s interest per year!

That means we are spending approximately 15% of our revenue and 12% of actual expenditures just on interest.

There is also the issue of state and local pension funds, many of which have vast future obligations that are poorly funded and will likely remain so, given these entities’ precarious financial condition. They should probably be buying more Treasury paper, but it’s not clear that they can.

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Other natural buyers are overseas. You hear a lot about China’s owning so much of our government debt. It’s true, but to some degree they have little choice. So long as the US runs a trade deficit with China and we insist on paying for our imports with dollars, China will probably continue to use those dollars to buy dollar assets with that export revenue. It can happen indirectly: Maybe China buys raw materials from Australia with the dollars, and then the Australians buy dollar assets. But in any case, the amounts are so vast that the Chinese gravitate toward the most liquid dollar asset –Treasury bonds.

China would like to convince its trade partners to deal in renminbi, and the partners are very slowly coming around. This is happening especially through China’s gigantic One Belt, One Road infrastructure initiative. The Asian and African nations where China is building ports, railroads, and other facilities are being “encouraged” to accept renminbi in payment and then use the currency to buy Chinese goods. But the simple fact of the matter is that a lot of the projects for One Belt, One Road require the spending of actual dollars.

That Chinese process is unfolding slowly. I don’t worry about China’s suddenly deciding to boycott US bonds. The Chinese don’t presently have that choice. However, they firmly intend to reduce their dollar dependence wherever possible. I don’t see them volunteering to lend us significantly more cash than they do now. And indeed, they have been reducing their dollar purchases – significantly.

OPEC is another once-reliable lender that is becoming less so. The reason isn’t complicated. Growing US shale production reduces our need to buy oil from OPEC countries, in the Middle East and elsewhere. We are buying 7 million barrels per day of oil less from outside the US than we used to. If OPEC countries ship us less oil and gas, we ship them fewer dollars, and they lose capacity to buy our debt, even if they want to.

In fact, federal debt held by foreign investors rose from about $1 trillion in 2001 to around $6 trillion in 2013, but it has more or less gone sideways since that point. China and Japan are no longer buying large amounts of US debt. They’re not selling it, either.

Look at it this way. I have a few fairly wealthy friends who are aggressive gold bugs. But when I ask them privately whether they are adding much to the actual physical gold they own, they say, “Not so much.” Even though they are firmly convinced that gold is eventually going to $10–15,000, their appetite to increase their gold holdings seems to be sated.

In the same way, China and Japan and many other foreign countries seem to be saying, “We have enough US bonds; let’s see if we can find some other way to spend our money.”

Please note that Japan, Australia, and Europe all have initiatives to build infrastructure and to be part of the growth that is going to be happening along with One Belt, One Road. China is entirely comfortable with those moves, since that is money they don’t have to spend – all they really need is the transportation infrastructure to move their products back and forth. They are perfectly willing to let Europe and Australia help build out Africa and Southern Asia.

And while the matter doesn’t get much play, and the Trump White House doesn’t seem to notice, the renminbi is actually quite strong. Chinese consumers are in the best shape they have been in for a long time, and they are using the strength of their currency to import goods, which typically have to be bought in dollars.

Further, many of the large state-owned enterprises have dollar-denominated debt that is essentially guaranteed by the Chinese government. Some of those dollars are going to come back to pay lenders, wherever they may be from.

You can go to this link to see how much each government around the world has actually invested in US Treasury securities. Interestingly, Ireland and the Cayman Islands are in third and fourth place behind China and Japan. At one point this past year, China actually had a little less in Treasury securities than Japan did, but they are both above $1 trillion total. The next four countries combined are up to $1 trillion+ total. And so on. You will also notice that many of the 10 largest holders are associated with major banking centers. And while their appetite is still rising, it is not growing by much.

Foreign buyers may represent another $400 billion available this year to purchase US Treasury securities. That still means we have to find at least $1.5 trillion from US sources. The smart money suggests that interest rates are going to have to go up in order to attract those buyers. That is one of the reasons we are seeing the very unusual circumstance of interest rates rising at the same time the stock market is falling out of bed.

Sidebar: The US 10-year yield is at 2.86% as I write. That is up from 2.05% last July, but is still lower than it was little over four years ago, when it hit 3%. Then, 3% 10-year yields didn’t stop the bull market.

As you can see, our lender search won’t necessarily be quick or easy. There is one sure way to scare up lenders … but it has a few drawbacks.

Coup de Grace

The US financial industry is extremely adept at evaluating credit risk for individual borrowers – or at least it thinks it is. Most folks can get a loan if they want one, but your interest rate will reflect your creditworthiness.

Similarly, Treasury can borrow all it needs by paying higher rates. That’s not the preferred outcome, but it is probably what will happen. We are already seeing rates trend upward as the benchmark 10-year climbs toward 3% from near 2% just 8 months ago. This rise also reflects inflation expectations, but the growing supply of Treasury debt is still the key.

Last week may be just a hint of what is coming. Credit markets are nothing more than borrowers competing against each other for lenders. The Treasury competes with investment-grade corporates, who compete with high-yield issuers. Then you have municipal bond issuers and many smaller debtors. They all need cash, but there is only so much to go around.

Rising Treasury issuance will force other borrowers to pay higher rates, which will in turn make Treasuries buyers demand higher rates. The process feeds on itself. Borrowers eventually find debt service taking a bigger bite out of their income. This burden leaves them less to spend on other goods and services.

Meanwhile, as time passes, borrowers who locked in lower rates during the QE years will need to refinance and will find they must pay sharply higher rates. Some won’t be able to do so and will go out of business, laying off workers and leaving their own lenders holding losses. This process will be extreme for issuers of high-yield bonds. As noted last week, there is now a drastically increasing amount of high-yield bond debt that has to be rolled over every year.

That process eventually adds up to a recession, which makes government spending rise even more as people lose jobs. How far away are we from that point? I still don’t expect a recession this year, but the risks will rise as we get into 2019. From there, the picture worsens quickly.

I don’t want to leave you depressed, so I’ll stop here. None of this is inevitable, but neither is it unlikely. Now is the time to get ready.

Sonoma, San Diego and SIC, and Elsewhere

In three weeks Shane and I will be going to Sonoma, where I’ll speak at my Peak Capital friends’ annual client conference. Then we’ll come back to Dallas, where I will speak at the S&P Financial Advisors Forum in downtown Dallas on Tuesday, February 27. If you are an investment advisor, sign up and let’s try to make sure we get to chat. I always like to talk to my readers.

After that, I’ll continue preparations for the Strategic Investment Conference. This is really going to be the best conference we have ever done, and you don’t want to miss it. We have been holding teleconferences with the various speakers on what they’re going to be presenting and how we’ll work the moderating and Q&A panels, and I’m adjusting the lineup a little to make the ideas flow better.

If the markets have been a little confusing the last week or so, there is no place better than the SIC to get a handle on what’s coming. I have some of the best economists and market strategists flying in from all over the world. There will be a special emphasis this year on looking at the social and technological changes that are coming in the next 10 years.

Our Thursday night at the conference, the dinner presentation will feature Democratic pollster Pat Caddell, who saw the fragmentation of society that led to Trump before anybody else did; Neil Howe, who understands the Millennial generation better than anyone else; Steve Moore; and myself, discussing what we all see as the coming fragmentation of society. And I guarantee you, it will have significant meaning for your investment portfolios. It is time to position yourself for a world that is going to be transforming.

And we have so much more at SIC this year. We have just finalized the last couple of speakers, who will address the recent volatility. I always try to leave a spot or two open to cover the questions that are currently most on the minds of attendees.

As I’ve said before, conferences are my artform. You don’t simply gather a bunch of speakers. You find the right speakers and put them in the right order in order to build on the information presented from the very beginning to the very end.

You won’t want to miss the presentations by Niall Ferguson and David McWilliams, nor their discussion/debate right after. I’m looking for a joke that begins something like, “A Scotsman and an Irishman walk into a bar and sit down next to an American.”

And let me close with something from the Ministry of Silly Indicators (located down the hall from the Ministry of Silly Walks). A friend (whom I cannot name) began to muse about whether the world would feel better on Monday morning after the Winter Olympics’ opening ceremony. He went back and looked at the last four Winter Olympics. Going into each of them, the market was in either a downturn or a serious correction. And on every occasion the market turned back around on Monday and went on to make new highs. He did admit that this was a ridiculous indicator, but he thought it was amusing.

And with that brief bit of levity, it is time to hit the send button. Let me wish you a great week! And stop procrastinating! Sign up for the SIC and see me in San Diego in a month.

Your wondering who is going to buy $2 trillion worth of Treasury securities analyst,
John Mauldin


The markets deliver a shock to complacent investors

Out of a clear blue economic sky, volatility returns and may linger

EVERY good horror-film director knows the secret of the “jump scare”. Just when the hero or heroine feels safe, the monster appears from nowhere to startle them. The latest stockmarket shock could have been directed by Alfred Hitchcock. The sharp falls that took place on February 2nd and 5th followed a long period where the only direction for share prices appeared to be upwards.

In fact the American market had risen so far, so fast that the decline only took share prices back to where they were at the start of the year (see chart). And although a 1,175-point fall in the Dow Jones Industrial Average on February 5th was the biggest ever in absolute terms, it was still smallish beer in proportionate terms, at just 4.6%. The 508-point fall in the Dow in October 1987 knocked nearly 23% off the market.

Still, surprise rippled round the world. Between January 29th and early trading on February 7th, the MSCI Emerging Markets Index dropped by 7.5%. The FTSE 100 index fell by 8.2% from its record high, set in January. A late recovery on February 6th, in which the Dow rebounded by 2.3% (or 567 points), restored some calm.

What explains the sudden turmoil? Perhaps investors had been used to good news for so long that they had become complacent. In a recent survey investors reported their highest exposure to equities in two years and their lowest holdings of cash in five. Another sign of potential complacency was the unwillingness of investors to pay for insurance against a market decline, something that showed up in the volatility, or Vix, index. Funds that bet on the continuation of low volatility lost heavily (see article).

The wobble may also reflect a decision by investors to rethink the economic and financial outlook.

Ever since 2009 central banks have been highly supportive of financial markets through low interest rates and quantitative easing (bond purchases with newly created money). There was much talk of an era of “secular stagnation”, in which growth, inflation and interest rates would stay permanently low.

But the Federal Reserve and the Bank of England are now pushing up interest rates, and the European Central Bank is cutting its bond purchases. Future central-bank policy seems much less certain. A pickup in global economic growth may naturally lead to fears of higher inflation.

The World Bank warned last month that financial markets could be vulnerable on this front.

Bond yields have been moving higher since the autumn; the yield on the ten-year Treasury bond, 2.05% on September 8th, reached 2.84% on February 2nd. On that day American employment numbers were released, showing that the annual rate of wage growth had climbed to 2.9%. That suggested inflation may be about to move higher. Furthermore, the recent tax-cutting package means that the federal deficit may be over $1trn in the year ending September 2019, according to the Committee for a Responsible Federal Budget, a bipartisan group. Making such a large amount of bonds attractive to buyers might require higher yields.

Higher bond yields are a challenge to the markets in a couple of ways. First, by raising the cost of borrowing for companies and consumers, they may slow economic growth. Second, American equity valuations are very high. The cyclically adjusted price-earnings ratio (which averages profits over ten years) is 33.4, compared with the historical average of 16.8. Equity bulls have justified high stock valuations on the ground that the returns on government bonds, the main alternative asset class, have been so low; higher yields weaken that argument.

Most analysts seem to think that the latest equity decline is a temporary setback. BlackRock, the world’s largest asset-management group, has called it “an opportunity to add risk to portfolios”. Economic-growth forecasts are still strong. Fourth-quarter results for companies in the S&P 500 index have so far shown profits up by 13% and sales 8% higher than the previous year. Tax cuts will give profits a further lift and companies may return cash to shareholders via share buy-backs. All this will provide support for share prices.

Meanwhile inflation worries seem premature. Core inflation in America (excluding food and energy) is just 1.5%. Despite a higher oil price, Bloomberg’s commodity index is nearly where it was a year ago. The same goes for American inflation expectations, as measured in the bond market.

Two issues will determine whether analysts are right to be sanguine. The first is whether the recent gyrations in the stockmarket were reactive, responding to the recent rise in bond yields, or predictive, in the sense of spotting future trouble.

The second relates to the theories of Hyman Minsky, an economist who argued that when growth has been strong for a while, investors tend to take more risk. This risk eventually rebounds on them, just as in 2007, when subprime mortgage loans proved worthless. Perhaps the slump in volatility-based funds or even crypto-currencies could cause a crisis at some financial institution, inflicting a dent in confidence more generally.

For the moment such dangers seem possibilities rather than probabilities. But like a horror-movie audience, once investors have been scared once, they may prove twitchy for a while.

Donald Trump has been lucky with the US economy

He is taking credit for the continuation of a post-crisis recovery begun under Obama

Martin Wolf

So I think you have a brand new United States.” That was Donald Trump’s boast in his speech to the business elite gathered at the World Economic Forum in Davos. So how, if at all, is America “new”?

How might this belief of Mr Trump’s affect his global economic agenda? Why did Mr Trump, who shocked Davos, by stating at his inaugural that “Protection will lead to great prosperity and strength”, become only the second US president to visit the annual meeting in Switzerland, after Bill Clinton, in 2000?

Mr Trump’s main aim, it was clear, was to assert that “after years of stagnation, the United States is once again experiencing strong economic growth”. Moreover, it is “open for business”. These and similar claims on employment and consumer and business confidence ran through his speech. It is true that the US economy is strong; it is not true that this follows years of stagnation.

Between the second quarter of 2009 and the end of 2016, the US economy grew at a compound annual rate of 2.2 per cent. Over the past four quarters, it grew by 2.5 per cent. That is not a significant change. The big shift in growth — downwards, unfortunately — was after the financial crisis of 2008. The economy is 17 per cent smaller than it would have been if the 1968-2007 trend had continued. Since its recovery, in 2009, it has been on a far slower trend. This may change, but has not yet done so. The same is true for labour productivity, whose growth remains low. (See charts.)

The unemployment rate has indeed fallen under Mr Trump, from 4.7 per cent in December 2016 to 4.1 per cent in December 2017, a very low rate by historical standards. But this is a continuation of the downward trend since 2010. If anybody deserves the credit, it is the Federal Reserve, for policies too often condemned by the Republicans. Eighty-six per cent of men aged 25-54 had jobs in December 2017. This is a percentage point higher than a year earlier, but 5.6 percentage points higher than in January 2010. Unfortunately, it is still below the previous cyclical peaks of nearly 90 per cent in 1999 and 88 per cent in 2007. The proportion of prime-aged women with jobs is also below levels in 2000.

Mr Trump is particularly enthusiastic about stocks, claiming that the market is “smashing one record after another”. This is not wrong. In terms of Robert Shiller’s cyclically adjusted price/earnings ratio, valuations of the US market are as high as in 1929 and have been exceeded since then only by the exalted valuations of 1998, 1999 and 2000. The rise of the market in the last year is quite remarkable, given how high it already was. But this should be a worry, not a boast. Mr Trump may soon come to regret lauding a high stock market. It is at no president’s beck and call.

An argument for hoping that better times will soon be here is the huge tax cut for business. It is quite unlikely, however, that this will unleash a flood of investment and higher underlying economic growth. A more plausible view is that it will mainly increase stock prices, wealth inequality and the speed of the competitive race to the bottom on taxation of capital. British experience on this is sobering. The slashing of UK corporate tax rates to 19 per cent has done little for investment or median real wages. The hope that it proves any different in the US is likely to be disappointed.

Briefly, Mr Trump is taking credit for the continuation of a post-crisis recovery begun under his predecessor. This is no “brand new” economy. He has been lucky. Provided the stock market does not blow up, he may stay lucky. Yet the question is how a lucky Mr Trump will behave. Will a man who feels he is on a winning streak be more demanding or more accommodating?

A particular concern is trade policy. On this, Mr Trump has stated: “We support free trade, but it needs to be fair and it needs to be reciprocal. Because, in the end, unfair trade undermines us all.” This is not new rhetoric.

The optimistic view is that we are going to see more of the sort of measures announced last week on solar panels and washing machines. These are foolish, but standard. Even the renegotiation of the North American Free Trade Agreement might be a damp squib. Now that the other 11 participants in the Trans-Pacific Partnership have, to their credit, agreed to go ahead, Mr Trump even says that: “We would consider negotiating with the rest, either individually, or perhaps as a group.”

The pessimistic view is that the administration is hooked on fundamentally crazy doctrines: the US trade deficit is the result not of macroeconomic imbalances, but of cheating on trade policy; in addition, the way to eliminate this deficit is via new bilateral deals with all important trade partners. This approach would blow up the multilateral trading system. It is also incompatible with market economics. Only planned economies could attempt the bilateral balancing in which Robert Lighthizer, the US trade representative, and his master apparently believe. An aggrieved superpower armed with such a benighted doctrine could do immense damage to the global economy and international relations.

How then should we evaluate the confident and emollient Mr Trump we saw in Davos? His boasts may be empty, but he has indeed been lucky in inheriting an economy enjoying a strong post-crisis recovery. The economy should remain his friend, so long as he does not trust too much in the stock market.

That is good news for him. A strong US economy is good news for the world, too. A confident Mr Trump might not be. The question is how he reacts. Will he be more reasonable or more intransigent? His speech did not provide all the answers. Uncertainty still reigns.

How Did That Get Into My Bond Fund??

Towards the end of financial bubbles, people who previously paid little attention to things like “quality” start trying to figure out what they actually own. The result is either funny or terrifying, depending on the point of view.

This time around bonds are (finally) getting a closer look. From today’s Wall Street Journal:

Decade of Easy Cash Turns Bond Market Upside Down
Debt deals set records from Tajikistan to East Rutherford, N.J., as investors keep hunting yield. 
Last fall, a hydroelectric dam in Tajikistan, the government of Portugal and a cruise-ship operator all issued debt at unusually low interest rates. The seemingly unconnected deals are part of a proliferation of aggressive bond sales influenced by a decade of loose monetary policy and a demographic shift in global investing. 
Historical limits on who can borrow, and at what cost, have broken down as fund managers agree to previously unpalatable terms. 
Central bankers in the U.S., Europe and Japan helped shape the new breed of deals by simultaneously purchasing over $1 trillion in high-quality bonds since 2009 and lowering benchmark interest rates to jump-start their faltering economies. Modest economic growth came, but the strategy crowded private investors out of safe debt, prompting them to buy riskier bonds to boost returns. 
Retiring baby boomers amplified the trend by moving their investments away from stocks into bonds, boosting assets in U.S. bond mutual funds to $4.6 trillion in November from $1.5 trillion a decade earlier, according to the Investment Company  Institute, a trade group for investment firms.
 The article goes on to present some examples of bonds that might not exist in less bubbly times.

Here are three:
  • Tajikistan borrowed $500 million to finish construction of a hydroelectric dam that was started under the Soviet Union. This is one of the world’s most corrupt countries – a fact noted in the offering prospectus — and the dam’s electricity will be sold to Afghanistan, which, as most Americans know, is in the middle of a civil war that the “good guys” might easily lose (also mentioned in the prospectus). The deal’s investment bank, Citigroup, initially marketed the bonds to yield 8% but received such a warm welcome that it cut the rate to 7.1%. Buyers included big U.S. firms like Fidelity, which bought $14 million of the bonds, presumably to boost the yield of funds sold to retirees.

  • The American Dream Mall in East Rutherford, N.J. broke ground in 2003 but ran out of money to finish construction. In 2017 the mall’s current owner—its third—employed Goldman Sachs to sell $1.1 billion of 6.9% muni bonds, fully half of which were bought by the Nuveen fund family. “Unlike most malls, American Dream will derive most of its revenue from experiential attractions that can’t be replicated online, rather than depending on retailers,” said a Noveen executive.

  • On Nov. 8, Portugal sold €1.25 billion ($1.55 billion) of 10-year bonds that yielded 1.94%—the lowest rate ever for the country. Portugal needed an international bailout in 2011 and still has a junk credit rating. It’s one of the most heavily indebted countries in Europe, but the auction set its borrowing cost below that of the U.S. government, which sold 10-year bonds in November to yield 2.31% [those bonds now yield 2.7%].

What does all this mean? In a nutshell, crazy stuff has been happening under the placid surface of the fixed income market. None of the three bonds profiled here are especially good bets, and retiree and pension fund portfolios are full of similarly toxic paper.

When a few such deals blow up – as bubble assets always eventually do – investors will start wondering what’s going to blow up next. And they’ll find not just a few but many, many bad ideas lurking in their “low risk” accounts. The resulting stampede for the exits will look familiar to anyone who lived through the tech stock and housing busts of previous decades.

With one big difference. This time around crappy, crazy paper is not just in tech stock and ABS portfolios. It’s everywhere. Trillions of dollars of sovereign debt will tank along with the sketchy shopping mall and emerging market infrastructure bonds. The resulting bust will be more broad-based and therefore way more interesting than anything that’s come before.

The Dollar Breakdown: A Sign of Inflation to Come?

By Mishka vom Dorp


Recently, we saw the dollar index (the DXY), which measures the USD against a basket of the world’s major currencies, break below its support of 91 for the first time since January of 2015 (Figure 1). This event may signal the most important trend of 2018: the breakdown of the dollar.

Figure 1: Daily Dollar Index (DXY)  Source: Thomson Reuters Eikon

The recent drop of .96 percent was the second largest drop in over a year and caught many traders by surprise given the recent strong U.S. retail sales data which increased their expectations of a rate hike in March to 75 percent.   Some of this selloff can be attributed to the strengthening Euro that came after the German Chancellor, Angela Merkel, announced an agreement to form a coalition government.

This deal had been struck after months of negotiations while the weakening dollar has been a year-long trend. Shortly after President Trump was elected in November of 2016, we saw the dollar rally over 5.5 percent only to hit a peak of over 103 in December of that year.  

In December of 2016, I wrote that a strong dollar would be the biggest headwind against the Trump administration’s domestic economic policy agenda: 

“If Donald Trump plans on bringing manufacturing jobs back to the United States, the dollar will be his main enemy. Since Trump’s election victory, the central bank's dollar gauge has risen over 4 percent against a basket of major currencies (Figure 2):

Figure 2: Broad Index of the Foreign Exchange Value of the Dollar      Source: Bloomberg

This should worry the President-elect since exports and manufacturing jobs will remain uncompetitive as long as the dollar continues to strengthen. Sure, he can place disruptions in the market such as tariffs to make foreign goods less competitive, but that would start an international trade war which would be a zero-sum game. Instead, the President-elect, once sworn in, can manufacture competitiveness through fiscal policy. With Trump’s planned tax cuts coupled with his planned infrastructure spending … the fiscal policy measures once implemented will be highly inflationary which should be good for gold [and bad for the dollar].” —Is it Time to Catch a Falling Knife? Dec. 15, 2016.

Furthermore, a strong dollar would likely exacerbate the U.S. balance of trade deficit by making foreign goods cheaper. Both things Trump has stated multiple times he is looking to fix and he himself acknowledged the best way to do this is by having a weaker dollar. 

I also wrote about Fed Chairman Janet Yellen who, with her recent hawkish shift, is seen as the biggest roadblock for the Trump Administration and its wish to manufacture a week dollar if the Fed continued to raise rates:

“Janet Yellen, the Chair of the Board of Governors of the Federal Reserve, has her term ending on February 3rd, 2018. The Fed’s main mandate is to keep inflation rates at 2 percent. With an inflationary fiscal policy regime implemented by Trump, Janet Yellen could be the only person to stand in Trump’s way. That is why Trump will most likely not  reappoint Yellen, and instead appoint someone who would be more amenable to keeping rates low. Furthermore, there are two vacancies on the board and they will most likely be dovish replacements.“ —Is it Time to Catch a Falling Knife? Dec. 15, 2016.

So it did not come as a surprise when Trump announced he would be replacing Yellen with Jerome Powell as his choice to lead the Fed in November of last year.

With Powell set to take over in February, it is likely he will take an even less aggressive approach to raising rates than that of Yellen. Either way, the weaker dollar has helped sustain gold’s buoyancy despite the five rate hikes we have seen since 2015 (Figure 3).

Figure 3: Gold (yellow) vs DXY (purple)   Source: Thomson Reuters Eikon

Looking back over the past year, one can see there is a strong inverse relationship between gold and the dollar which has only strengthened over the past month. I believe the recent slide below support levels opens the door to a rally that could be similar to what we saw in the early 2000s, when the DXY broke down from 120 and fell all the way to the low 70s in 2008 (Figure 4).

Figure 4: Gold (yellow) vs DXY (purple)   Source: Thomson Reuters Eikon

So where does gold go from here?

There are two major factors which I believe influence gold. The aforementioned dollar and real interest rates, which is the nominal rate set by the Fed minus inflation. A weaker dollar obviously means a stronger gold price in dollar terms but the real rate’s influence is a bit more convoluted. Since both Treasurys and gold are seen as safe-haven assets, investors who are worried about market risk have a choice to park their savings in a “risk free” asset that has a yield (Treasurys) or one that does not (gold). If real rates are positive, investors will likely favor Treasurys, since they provide a yield above that of inflation. However, when the inflation rate is greater than or equal to the nominal rate, investors prefer gold, since parking cash in Treasurys yields a negative return.

However, despite the Fed's efforts to manufacture inflation through historically low interest rates and large-scale asset purchase programs, we still have yet to see the Consumer Price Index (CPI) rise significantly, hence real rates have remained in positive territory. The best way to view real rates is by looking at the yields of Treasury Inflation Protection Securities (TIPS), where the principal is adjusted up and down based on CPI data. Looking at the 10-Year TIP (Figure 5), one can see the inverse relationship of TIPS to gold.

Figure 5: 10-Year TIPS (orange) vs US Gold Spot Price (yellow)      Source: Thomson Reuters Eikon

What arguably sparked the end of the 5-year bear market in gold was the fall of the TIPS yield from 0.7 percent in January 2016 to negative real interest rates by July 2016. Since then, the 10-Year TIPS yield has bounced off the bottom to .53 percent.

With the recent decline in the dollar, from a U.S. consumer’s perspective, foreign goods and services will now cost more than they did a year ago considering the dollar has declined over 12 percent. With over 27 percent  of the of the U.S. GDP made up of imported goods and services, the effects will be felt far and wide. Though inflation takes time, there is a very good chance we could see real interest rates begin to decline over the coming year.

Though it is likely the Fed will attempt to counteract inflation by raising rates, it’s anticipated that President Trump will stack the deck with more dovish board members with the three current vacancies of seven total positions. From 1945 to 2001, the average economic expansion following a recession in the U.S. was just 
shy of five years. We are now into the ninth year of expansion and it is likely the Fed will have very little room to adjust rates down without going into negative territory once the next recession hits.

For now, I believe we will continue to see a weaker dollar, more inflation and a less aggressive Fed. This combined should all be positive for gold and the miners that extract the yellow metal.  The bull market which started in 2016 is now once again in full swing after a lackluster 2017. For those investors sitting on large cash positions, I believe now is the time to consider deploying funds into quality explorers, developers and producers. 

Trumponomics Is Failing on Growth

Simon Johnson 

People who call themselves Dreamers protest in front of the Senate side of the US Capitol

WASHINGTON, DC – US President Donald Trump and his Secretary of the Treasury, Steven Mnuchin, have promised an economic miracle. They argue that when the United States adopts their policies, it will consistently achieve annual economic growth above 3%, or even above 4%.

After a year of being in charge, pushing hard on deregulation, and getting what it wanted in terms of tax cuts, how is the Trump team doing?

We are still in the early days, but the results so far have been disappointing. And the US’s medium-term prospects for sustained growth could be endangered if Trump pursues the policies he claims to want.

Trump has repeatedly argued that America’s overall economic performance in 2017 should be seen as the direct result of his policies, and he has made a big deal out of the third-quarter growth rate, which was initially reported as 3.3%, then revised down to 3.2%. Yet, in the fourth quarter, growth was down to 2.6%, and initial estimates suggest that overall growth for the year will not surpass 2.3%. That is lower than what was achieved under former President Barack Obama in 2014 (2.6%) and 2015 (2.9%).

In fact, under Obama, the quarterly growth rate surpassed 3% seven times, and even reached 4.6% on two occasions. From the third quarter of 2009, growth was positive in every quarter, save two. But not only was headline growth sturdy under Obama; his administration also presided over considerable job growth – the economy added more than two million jobs annually in seven out of his eight years in office – as well as falling unemployment and higher labor-force participation.

Far from a miracle, Trump has failed to deliver any kind of improvement to economic growth. To understand why, it helps to remember that Trump has not actually done much in office. Notwithstanding his constant bragging about deregulation, the total economic impact of his regulatory repeals has been trivial relative to the size of the economy.

Moreover, the tax cuts that Trump signed into law at the end of 2017 will have very little positive impact on growth. The tax package is primarily about redistribution from middle-income households – particularly those in high-tax, Democratic-leaning states such as New York and California – to the richest Americans.

People who own capital that is already in place – such as large buildings in New York – will do well. But the law does not offer much of an incentive to invest in new capital, either by launching a new company, developing new products, or investing in new plants and equipment. Furthermore, as I pointed out at a recent Intelligence Squared US debate in New York, the law may actually have a negative effect on research and development, which is a key driver of long-term growth in the US.

Looking at the 2017 data, there is no sign that business investment ticked upward under Trump. Yes, this is a volatile data series, because it rises and falls with the usual course of events. But it is also another area where Obama set the bar high during his two terms.

The most positive thing that can be said about Trump’s first year of economic policymaking is that he did not deliver on his campaign promise to disrupt trade. The North American Free Trade Agreement (NAFTA) remains intact, as do trade relations with China and other major US partners. The administration did impose tariffs in January on solar panels and washing machines, but those are small relative to the size of the economy. As a result, Trump has not caused a massive, self-inflicted recession, and we should perhaps congratulate his team more often for avoiding that scenario.

Then again, we are entering a period of heightened Trump-related risk. Having terminated the Deferred Action for Childhood Arrivals (DACA) program last year, Trump has put 800,000 young people who were brought to the US illegally as children in danger of being thrown out of the country.

Given that these are highly productive people who contribute heavily to the US economy, Trump’s approach could have dire economic, not to mention human, consequences. Trump and his allies are also pursuing sharp reductions in legal immigration, which would reduce the US’s medium-term growth prospects, perhaps significantly.

Trump has not abandoned his threat to rip up NAFTA, either. If he does take any steps in this direction, it will not be helpful to the US economy. Ironically, it could also do great damage to the Mexican economy, likely resulting in increased undocumented migration to the US. Without any such disruption, however, demographic trends suggest that migration from Latin America to the US will continue to decline steadily.

The biggest danger that Trump poses concerns financial deregulation. Both the Trump administration and the Republican-led Congress are attempting to roll back protections against systemic risk that were put in place after the 2008 financial crisis. Unfortunately, these kinds of attempts to juice the economy typically end badly. When George W. Bush’s administration did the same thing, we were left with the Great Recession.

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.