What is the current state of the U.S. Economy? This report was written to answer this question and its impact on currency and stock market. There are many reasons, why the next few weeks will be critical to the immediate stabilization of the economy, as there are many factors pointing to a further deterioration of the U.S. economy:
1) GM Bankruptcy
Imminent bankruptcy filing by General Motors as early as next week, as GM is expected to miss a $1 Billion debt payment on June 1 (GM won't make $1B June debt payment) and fail to submit a sustainable restructuring plan by June 1. GM is on life support by the government and the only way to prevent a catastrophe is by "injecting" billions of more dollars into the company, while it is restructuring (GM borrows $4 billion more, prepares for bankruptcy). Why is this such a big deal? GM employs over 230,000 employees (General Motors Corporation Profile) and millions more through GM’s relationships with ancillary service providers and OEM suppliers. A much “leaner” (read “smaller”) GM would employ a small fraction of the number of employees it had before the filing. A GM bankruptcy would also further harm the U.S. image across the world, as large conglomerates like GM are often equated with the strength of the U.S. at large. With GM following in Chrysler’s footsteps, expect to see the unemployment rate, currently at 8.6% across the U.S. (U.S. Unemployment Rate), to be much higher.
2) State of the Union
California is the first of the 50 states, who may actually have to default on its Treasury bond payments. As it is not possible for a state to declare bankruptcy, the only option is for federal government to offer some of the TARP funds to help California finance its debt-laden system. By law, the individual states are not allowed to run a deficit and must balance their budget each year. The federal government indicated that they would not bail out entire states. Our good friend Arni, the Gubernator, has already announced that with rainy day funds depleted and in order to cope with the revenue shortfall, he will have to take some drastic measures to balance the budget: cut funding for prisons and release prisoners early, cut welfare, cut school funding, cut the number of teachers, fire, health services, and police (Golden State Bailout). California is only the first state to succumb to the financial fiasco. According to a national survey by the National Conference of State Legislatures
"Fifteen states are forecasting double-digit gaps in FY 2010. The largest are in Arizona (24.2 percent), New York (20 percent), California (18 percent), Wisconsin (17.2 percent), Minnesota (14.7) and Kansas (14.5 percent)."
Estimated Budget Gap FY 2009
source: http://www.ncsl.org/summit/budgetmap.htm
Estimated Budget Gap FY 2010
source: http://www.ncsl.org/summit/budgetmap.htm
As state revenue is anticipated to decline for at least the next 24 months, expect to see more state and municipal bond payment "delays" and budget cuts.
3) The U.S. Bond market and Interest Rates
This has been a big concern for many years and the most influential of all factors. As long as the treasury was able to print more dollars by selling U.S. Treasury bonds on auction and find buyers at near zero percent interest, all was hunky-dory. Last week we have seen the further deterioration and first indications, that bond sales at near zero percent will not hold up too much longer. According to Bloomberg, the
"10-year notes climbed above 3.4 percent for the first time since November as investors also raised concern about the possibility that record supply of Treasuries to pay for a mounting budget deficit" (U.S. 10-Year Note Falls Most Since June on Supply, Credit)While this is not a big deal in-and-of itself, the worrisome part is that international investors are starting to send yields up as the long term AAA status of U.S. treasury bonds is put in question. Issued bonds were trading at a discount last week compared to their par value, further indicating a potential rise in yield in upcoming auctions. To compensate and attract investors, yields will have to go up as risk goes up. While U.S. treasury bonds will probably maintain their Moody’s AAA rating in the short term, the rating agency has already indicated, that they may lower the credit rating if the financial situation doesn’t clear up. As they state:
"...[Moody’s was] comfortable with [their] triple-A sovereign rating on the United States but that it was not guaranteed forever".Read between the lines: "This is your 5-minute warning. Get ready for a lower credit rating and higher interest rates within the next 9 months if things don’t get better quickly". The UK is already suffering from a negative outlook, as their total debt is nearing 100 percent of GDP. On March 25, the UK experienced its first failed treasury auction since 2002, where there were insufficient buyers for the amount of offering (U.K. to Hire Banks for Bond Sales as Debt Load Mounts (Update2)). In order to prevent similar failure at next weeks U.S. auction, where the U.S. Government is expected to sell $101 Billion worth of bonds (TREASURY OUTLOOK-US bond market faces toughest supply test yet), Federal Reserve Bank meeting notes from April 28-29, 2009 revealed that the members of the Federal Open Market Committee
"agreed that it would be appropriate to continue making purchases in accordance with the amounts that had previously been announced--that is, up to $1.25 trillion of agency MBS and up to $200 billion of agency debt by the end of this year, and up to $300 billion of Treasury securities by autumn" (Minutes of the Federal Open Market Committee)The treasury is starting to lose control over bond yields, as artificially keeping U.S. Treasury rates low by buying their own treasuries until the economy rebounds, may no longer be effective. Expect to see Trillions more flowing into treasuries, pushing inflationary pressure and commodities prices up.
4) Bank failures and the FDIC
The rate and size of bank failures is increasing at an alarming rate. From 2000 to May 2008, there were a total of 29 bank failures. In the last 12 months alone there were a total of 55 failures, with the size of the failures increasing (Failed Bank List). With each failure, the Federal Deposit Insurance Corporation (FDIC) takes over responsibility of settling accounts and covering shortfalls, however the FDIC’s financial reserves are limited. FDIC’s chairman, Sheila Bair, warns that the agency’s funds could “quickly be used up in a flurry of bank failures” and that “without [special] assessments, the deposit insurance fund could become insolvent this year”. She warned that “a large number” of bank failures may occur through 2010 because of “rapidly deteriorating economic conditions.” (Bair Says Insurance Fund Could Be Insolvent This Year (Update1)).
As banks are recapitalizing, by deleveraging their investments and the Federal Reserve Bank mandating higher reserves, overall health of the banks should theoretically be improving. The problem is that the default rate on loans is increasing even faster, triggering additional capitalization requirements to cover for the defaults. Citibank and Bank of America have the short-term capacity and are in the process of recapitalizing by issuing follow-on offerings of common securities to the public, whereas smaller banks do not have this option. Expect to see further bank bailouts throughout at least 2010.
5) TARP (not the fish)
The Troubled Asset Relief Program originally devised to buy up to $700 Billion of toxic assets from financial institutions in order to strengthen the financial sector has now been widened to include insurance companies as well (Prudential, Allstate Among Insurers Cleared for TARP (Update3)). TARP is starting to look more and more like a wholesale instrument to pump money into any sort of troubled institution. While the accountability of TARP funds is very opaque expect to see the Treasury Department to announce additional bailout programs and the conversion of bailout funds to equity share (read “loan forgiveness”). While institutions have promised to repay funds as soon as possible, only 14 of 600+ institutions have actually repaid the funds since 2000. With $106 Billion remaining in the fund (Spend or save last of U.S. financial rescue funds?), the treasury is already working hard on devising new strategies to provide capital to failing corporations and institution.
6) The Real Bailout
The size of TARP funding is really irrelevant, when compared to the governments total bailout tab through various programs with commitments in excess of $12.2 Trillion in addition to the $700 Billion TARP funds (Adding Up the Government’s Total Bailout Tab). Of these committed funds, $2.5 Trillion have already been spent. With national debt at $11.3 Trillion (The Debt to the Penny and Who Holds It) – not accounting for the various committed but unused bailout funds, and GDP at around $14 Trillion (Wikipedia - United States), the U.S. is very rapidly reaching a debt to GDP ratio of 1, or stated differently, every dollar worth of product or service produced over a year of every single worker in the U.S. goes to pay back one dollar of debt. For FY2008, the debt service payments were the fourth largest category congress spent money on, right after the health care system, defense spending and social security. At the current pace of bailout spending, expect interest payments to become the largest item in the federal budget by the end of this year.
Source: http://www.federalbudget.com/
7) Social Security and Medicare
In addition to the bailout, the two largest government unfunded obligations are Social Security and Medicare. Conservative estimates predict Medicare’s unfunded present value of future obligations at $13.4 Trillion and Social Security’s unfunded present value of future obligations at $5.3 Trillion (Social Security, Medicare bleeding faster). That puts the projected budget shortfall for both funds at over $18 Trillion, or measured as a percentage of net present value of future GDP, over 100%. Additionally, as more and more people are opting for early retirement and calling it quits before the age of 66 (Early retirement claims increase dramatically), Medicare will exhaust its funds by 2017, two years earlier than expected. Social Security is not too far behind, as it is expected to be insolvent by 2037, not taking into accounting further deterioration of the economy.
8) U.S. Derivatives Market
The opaque over the counter traded U.S. derivates market, which includes options, credit default swaps and collateralized debt obligations amongst others, dwarfs any other market in comparison. The $194 Trillion U.S. over the counter market is over 27 times larger than the $7 Trillion exchange traded market (New U.S. derivatives rules could make odd partners). With little oversight and very complex models, this highly leveraged market is highly susceptible to any kind of unusual market conditions, such as the current one. As the underlying valuation models are primarily built on stochastic risk modeling, the high-fidelity input data into these valuation models only goes back to the early 1980’s and therefore does not go far back enough to accurately enough account for larger economic cycles. Failure of one large OTC trading bank would ripple through the financial system, and trigger a cascade of defaults around the world. For this reason the federal government decided to bail out Merrill Lynch, Bank of America and predominantly AIG, which has already received over $173 Billion in government funds. Federal government will continuing pouring in billions more to keep AIG alive, while trying to untangle the vast web of interrelated obligations. The following graph shows how intertwined AIG is with banks all around the world:
Source: AIG
The unwinding/deleveraging of the OTC market still has a long way to go, as more oversight is brought into the market. Due to the high leverage of the OTC market any drastic changes in the financial condition of the U.S. could have devastating effects on the derivatives market and threaten the banking system as a whole.
9) Recession vs. Depression
A recession is a general slowdown in economic activity over a sustained period of time, or a business cycle contraction (Wikipedia – Economic Recession). A decline of year-over-year of more than 10% is commonly defined as an economic depression, however this term is not formally defined.
"Considered a rare and extreme form of recession, a depression is characterized by abnormal increases in unemployment, restriction of credit, shrinking output and investment, numerous bankruptcies, reduced amounts of trade and commerce, as well as highly volatile relative currency value fluctuations, mostly devaluations. Price deflation or hyperinflation are also common elements of a depression." (Wikipedia – Depression (Economics))Two things must happen for a Recession to turn into a Depression:
1) a decline in real GDP exceeding 10%, and
2) a recession lasting 3 or more years (Diagnosing depression).
Let’s look at each point individually:
- Abnormal increases in unemployment: with an 8.6% unemployment rate, these conditions are given.
- Restriction of credit: definitely given, as banks are less willing to loan out money.
- Shrinking output and investment: Current indications by the U.S. Bureau of Economic Analysis indicate a quarter-to-quarter growth of approx. -6%
Source: U.S. Bureau of Economic Analysis
- Numerous bankruptcies: Lehman Brothers, Washington Mutual, World Com, Enron, Conseco, Chrysler, Thornburg Mortgage, PG&E, IndyMac, Calpine, United Airlines, Delta Airlines,… (20 Largest Public Company Bankruptcy Filings 1980 – Present)
- Reduced amounts of trade and commerce: spending slightly down overall – economic data pending.
- Highly volatile relative currency value fluctuations: yes (Dollar Approaches Year’s Low Versus Euro on U.S. Credit Concern).
While the U.S. economy is not quite in a Depression yet, it does not have far to go.
10) International Aspect – The U.S. Dollar as the World’s Reserve Currency
The United States dollar is the most widely-held reserve currency in the world today with over 64% of global currencies held in U.S. dollar denominated notes, 26% held in Euros and the rest in other currencies.
Source: Wikipedia – Reserve Currency
This has allowed the U.S. to run huge trade-deficits without immediate economic impact.
As of Jan 2009, China and Japan hold almost 45% of U.S. Treasury Securities.
Source: http://www.smartmoney.com/Investing/Bonds/The-Mysteries-of-the-Treasury-Market-Revealed/
China’s insatiable appetite for U.S. Treasury notes is coming to an end, as
“Beijing has called for a new international reserve currency in the form of the International Monetary Fund’s special drawing rights (a basket of Dollars, Euros, Pounds and Yen). China will soon want to see its own currency included in the basket, as well as the Renminbi used as a means of payment in bilateral trade.” (The Almighty Renminbi?)China’s diversification away from the U.S. Dollar will have significant impact on the valuation of the US Dollar with respect to other world currencies and to the US trade deficit.
In Japan,
"Japan's opposition party says it would refuse to buy American government bonds denominated in US dollars, if elected." (Japan 'would avoid dollar bonds')If the Japanese opposition party were elected to power, this would lead to further deterioration of the US Dollar.
With both Japan and China, holding a combined 45% of U.S. Treasury Securities, the effect of "diversifying" their reserves would be substantial. In such case, they may become net sellers instead of buyers in the near future.
11) Public debt as percentage of annual GDP compared to other countries
Let’s look at an international comparison of the Public Debt to GDP ratio worldwide.
Source: Wikipedia - List of countries by public debt
On an international scale, the United States ranks at position 27, after Japan, Germany, Canada and France. Let’s look at the following table comparing GDP, debt levels and Consumer Price Index Inflation rate:
Sources: Wikipedia - List of countries by public debt, Wikipedia - List of countries by GDP, Wikipedia - Field Listing - Inflation rate
There does not appear to be a direct correlation between the CPI inflation rate and the public debt as percent of annual GDP. If we use the numbers of “6) The Real Bailout” as additional public debt, this would put the U.S. debt level closer to 146%, still less than Japan’s debt level.
12) Inflation and the Stock Market – Historical View
In order to get a better understanding of the effects of inflation and hyperinflation on the stock market, let’s look at the Weimar Republic as example.
Source: A world of possible futures
From the chart above, we see that the real value of the stock market did not deteriorate significantly during the periods of hyperinflation. While Treasury bond holders fared less well, the stock market as a whole only suffered during the period of hyperinflation and recuperated thereafter.
13) The Path Ahead
While it is too early to predict if the U.S. will emerge from this financial fiasco anytime soon, economic indicators are pointing to the contrary. With state revenue shortfalls increasing, corporate bankruptcy rates going up, housing prices still falling at a record pace, banks being seized on a weekly basis, and bailout after bailout pumped into the economy, the U.S. treasury has stretched every aspect of financial responsibility to its limit and beyond.
It appears that the U.S. is close to being insolvent. When a country becomes insolvent it basically has three options:
1) Pay off debt
2) Default on some or all of its debt
3) Inflate the currency and pay back previous debt obligations with newly printed money.
From these three options, it appears that the U.S. has chosen the path of least resistance, by printing more of its own currency.
During the Weimar Republic, Germany was required to pay 132 billion Gold Marks in war reparations under the Treaty of Versailles. The debt burden was so disproportionate to their reserves that they had to inflate their currency to be able to service the debt. In 1920, 2 Mark would buy the equivalent of one loaf of bread. In January 1922, the price for one loaf of bread went up to 4 Mark. By May 1923, the price skyrocketed to over 1000 Mark and by October 1923, it went up to half a Billion Mark. Finally by November 1923, shortly before the monetary reform, one loaf of bread cost over 50 Billion Mark (Wikipedia - Inflation in the Weimar Republic).
In less than 1.5 Years, the price of bread went from a few Mark to Billions of Mark. Are we currently facing the same situation in the United States?
As stated by the President of the United States of America on May 22, 2009 in an interview on C-SPAN:
Steve Scully, C-Span: "You know the numbers, $1.7 trillion debt, a national deficit of $11 trillion. At what point do we run out of money?"
Obama: "Well, we are out of money now."(C-SPAN INTERVIEW TRANSCRIPT, President Barack H. Obama, May 22, 2009)
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Disclaimer
The above is presented for educational and/or entertainment purposes only. Under no circumstances should it be mistaken for professional investment advice, nor is it at all intended to be taken as such. The commentary and other contents simply reflect the opinion of the author alone on the current and future status of the markets and various economies. It is subject to error and change without notice. The presence of a link to a website does not indicate approval or endorsement of that web site or any services, products, or opinions that may be offered by them.
Neither the information nor any opinion expressed constitutes a solicitation to buy or sell any securities nor investments. Do NOT ever purchase any security or investment without doing your own and sufficient research. The author shall not in any way have any liability for any loss sustained by anyone who has relied on the information contained herein. The author is under no obligation to update or keep current the information contained herein. The analysis contained is based on both technical and fundamental research. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.
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