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Aggregator • MaxedOutMama • ID=77935


The Euro funnel cloud is forming. The bottom line is that many of the banks are now in a worse position than they were before the LTRO, so what to do? This wouldn't be so bad if Spain and Italy weren't still contracting, but they are.

William Dudley speech. Note that the "sustainable growth rate" for the economy is given as 2.25% annually. I still think that's too high, but consider what that assumption implies about federal deficits. Deficits always grow during downturns, and downturns are more frequent when growth rates are low. At that growth rate you would expect one at about every seven or eight years - and that's a minimal estimate.

To keep federal debt from growing faster than the economy over the long run at that sustainable growth level, one would need to limit deficits during expansions to no more than 1.5%. Crikey! To put that in perspective, on a nominal basis US GDP grew about 564 billion dollars in 2011, and debt held by the public grew by about 500 billion more. Real GDP only grew by about 212 billion from Q4 2010 to Q4 2011. Real GDP growth was 1.7% for 2011 on a YoY basis, or 1.6% on a rolling four quarter basis.

Or one could indulge in massive inflation, which would tend to shrink the pre-existing pot of federal debt relative to even real GDP. But don't expect investors to keep putting money into low-priced Treasuries if that happens - the cost of servicing the federal debt would rise dramatically. And consider the implications. Real GDP growth is a much better measure of ability to service debt, so inflating out of it really isn't an option UNLESS it can boost growth sharply and quickly.

US average interest rate in March on marketable securities is 2.187%. From here it may go up a bit. If you induce high inflation for long enough accompanied by real growth, those interest rates will probably double. Because so much of our debt is floated at short maturities, within a few years our average interest rate can double. Now figure this as a percent of real GDP (because you have to pay interest out of real GDP, i.e. taxes, or keep borrowing to pay interest):
floated debt 80% of GDP, average interest rate 2.2% = carrying cost of 1.76% of GDP.
floated debt 80% of GDP, average interest rate 4% = carrying cost of 3.2% of GDP.

So it is hard to see how inflation could boost real GDP. There's not margin in consumer incomes - cost rises are constraining spending and job creation, as B-Dud implies.

This is why investors are freaked out over Spain. It's supposed to reach the 80% level soon. It can't inflate out of debt, but the carrying cost of the debt compared to real GDP is mounting by leaps and bounds.

The only time a high-indebtedness country can really inflate out of debt is if most of its debt is in long term securities, so the inflation of the currency reduces the principal amount of your debt over a few years by much more than the increase in the average interest rate paid. However the cost of doing so is felt for years after the "surprise" inflation. Investors work on the "fool me once, shame on you, fool me twice, shame on me" rule and demand higher interest rates for years after your "surprise" inflation party.

Here is a useful treasury document as of Q1 2012 (fiscal), which contains the maturity profile for US floated debt:


I'm not making this up. The US has too short a maturity profile to be able to inflate our way out of the debt imbalance.

Right now we can get almost free money short term due to the Euro sovereign crisis. Since they are kind of going from bad to worse (proving the old maxim about committees) the US once again proves the prophetic capabilities of certain Canadians.

Approximately 46% of the debt is owed to foreign interests, so a rapid inflation of our currency could cause a massive funding crisis which would jack up interest rates far more than inflation alone would predict.

Thus, the US faces fiscal consolidation, not because we want to do it, but because any other course would make us all much poorer much faster. A paper discussing the situation from March of last year. Note that Spain's short maturity profile as discussed in that paper is one of the reasons why Spanish bonds are coming under so much pressure now. The last paper is very short. The striking difference between maturities at the end of WWII and now combines with the much poorer growth prospects of our current economy to make this a real issue.

So now Krugman and others are in the Leacock camp, but I personally am less confident of divine intervention. After all, the best bargain the Jews were able to work out over a few thousand years was "Here's the rules - you have to at least attempt to follow them and admit it and repent when you don't, or disaster will ensue." Running around and pretending there were no rules always worked out very badly in practice. It's tough to argue with thousands of years of history.

Hopes that the Fed will dash in and throw some money are daunted by March CPI. The "ex-food-and-energy" monthly increase is 0.2 and the annual is 2.3% - by no measure whatsoever has inflation fallen below the Fed target. Twelve month rolling increases are 2.4% for C-CPI-U, 2.7% for CPI-U, and 2.9% for CPI-W (which you have to look up here). The unadjusted one month change for C-CPI-U was 0.6. For CPI-U it was 0.8. For CPI-W it was 0.9. The SA monthly all-items increases are 0.3% for all categories. The Fed need not worry about deflation at this point.

Chinese GDP was reported at 8.1% (over the year). Quarterly 1.8%, annualized quarterly rate about 7.4% which is very much in line with the announced goal. Singapore's over the year was 1.6% (same as US!) The quarterly annualized change was 9.9%. In the first quarter of 2011 it was 19.7%. Singapore had a tough year, with two negative quarters. Japan is doing better, so Singapore ought to have a better year if all other things remain roughly stable.

US Treasury 10s, 7s and 5s are well in play now. This is pretty much a classic trader situation. There is not tons of product, especially on the 10s, so investor sentiment on certain types of economic news will move prices strongly, thus creating volatility, there's an underlying Fed stop-loss, so you don't have to pay for it, and odds of getting negative news from China and/or Europe to support lower yields are quite high. So far just under 2 is the limit, but we could easily have another 10 basis points in there if things get plug-ugly in Europe. Still I wouldn't go in a these prices. This is hot money.

I still don't see a clear path in Europe. The bottom line for the European Central Bank is that it is sitting on tons of yucky collateral. If it returns to bond-buying, it is left as the last-dollar investor. That is not a situation a central bank likes to be in - ECB desperately wants and needs the bailout funds to be buying these bonds to support values. ECB recently relaxed collateral rules again to let more banks participate in the Euro Toss Olympics. Over the short term that helped ECB, but now Mr. Market has turned to bite the hand that fed it, and will continue snapping away at the collateral value, especially since the banks are once more hung out there.

So within a week or two we should see some more talk over getting the next bailout fund underway - if Germany cooperates. That's the big if and the next big issue, because the money has to be committed. It's doubtful that China will buy in big - it doesn't want to be last Euro either.
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